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•AUDITING 
THEORY  AND  PRACTICE 


BY 

ROBERT  H.  MONTGOMERY,  C.  P.A. 

of  the  firm  of  Lybrand,  Ross  Bros.  &  Montgomery.  Assistant  Professor 
of  Economics,  Columbia  University.  Formerly  Lecturer  on  Auditing, 
University  of  Pennsylvania  and  New  York  University.  Ex- President 
American     Association     of     Public     Accountants.         Attorney-at-Law. 


SECOND  EDITION 
REVISED  AND  ENLARGED 


NEW  YORK 

THE  RONALD  PRESS  COMPANY 
1916 


Copyright  1912  by 
ROBERT  H.  MONTGOMERY 


Copyright  1915  by 
ROBERT  H.  MONTGOMERY 


Copyright  1916  by 
THE  RONALD  PRESS  COMPANY 


All  rights  reserved 


TO 

E    S.  M. 

WITHOUT  WHOSE  INSPIRATION 

THIS    BOOK   WOULD    NOT 

HAVE  BEEN  WRITTEN 


M7  ■ 


PREFACE 

There  is  a  demand  for  a  practical  book  on  auditing  which 
up  to  this  time  has  not  been  met.  If  my  twenty- four  years  of 
continuous  experience  in  professional  accountancy  work  is  a 
sufficient  practical  training,  I  trust  I  have  established  a  prima 
facie  excuse  for  the  presentation  of  this  book,  which  contains 
more  of  practice  than  of  theory. 

Auditing,  in  its  broadest  sense,  is  the  most  important 
branch  of  accountancy.  During  the  early  years  of  my  clerk- 
ship in  the  office  of  John  Heins,  of  Philadelphia  (then  Presi- 
dent of  the  American  Association  of  Public  Accountants), 
and  later,  while  acting  as  an  instructor  in  the  School  of 
Accounts  and  Finance  of  the  University  of  Pennsylvania,  I 
strongly  felt  the  need  of  a  dependable  text-book  on  the 
subject.  My  attention  was  all  the  more  directed  to  the 
paucity  of  books  on  auditing  and  on  other  accounting  and 
cognate  subjects  by  contrast  with  the  full  and  comprehensive 
literature  of  the  legal  profession  which  I  had  found  of  such 
great  assistance  in  my  studies  preparatory  to  admission  to 
the  bar. 

Mr.  Dicksee's  work  on  auditing  was  for  many  years  an 
authority  in  American  offices.  In  1905  I  published  an 
American  edition  of  his  book,  in  which  I  omitted  the  statutes 
and  other  matter  which  related  solely  to  British  practice, 
and  rewrote,  or  left  unchanged,  the  parts  applicable  to 
American  practice.  The  book  met  with  such  success  that 
in  1909  a  second  edition  was  required. 

During  the  last  few  years,  however,  I  have  noted  in  the 
profession  a  radical  departure  from  the  principles  and  pro- 

V 


VI 


PREFACE 


cedure  enunciated  by  Mr.  Dicksee.  More  is  now  expected 
of  the  auditor,  and,  happily,  many  of  the  profession  have 
met  this  broader  demand  and  have  shown  that  the  services 
of  the  practitioner  must  extend  over  the  whole  field  of  busi- 
ness activity.  In  view  of  these  recent  and  important  de- 
velopments, I  feel  justified  in  giving  a  subordinate  place  in 
this  work  to  what  were  formerly  regarded  as  the  chief 
objects  of  an  audit;  and  what  I  consider  to  be  the  major 
objects  of  a  modern  audit  are  discussed  exhaustively. 

It  may  be  that  I  am  too  radical  in  some  of  my  interpreta- 
tions of  the  ideal  procedure.  Perhaps  to  follow  strictly  the 
rules  laid  down  in  this  book  would  require  more  time  than 
any  auditor  is  willing  to  devote  to  a  single  engagement.  The 
exigencies  of  a  particular  case  may  make  the  opportunities 
for  investigation  more  limited  than  the  auditor  would  wish 
them  to  be.  But  the  student  and  the  young  practitioner 
particularly  should,  nevertheless,  be  careful  not  to  restrict 
the  scope  of  their  theory  and  practice  until  they  have  con- 
sidered the  last  safeguard  which  can  be  applied  to  business 
transactions  and  have  followed  up  the  slightest  hint  which 
may  throw  light  upon  any  irregularity  in  a  concern  under 
audit. 

I  would  not  have  the  courage  to  present  this  book  to  the 
profession  if  it  had  not  been  for  the  commendatory  assur- 
ances and  helpful  suggestions  of  my  partners,  William  M. 
Lybrand,  C.P.A.,  and  Walter  A.  Staub,  C.P.A.,  and  my 
friend  Joseph  E.  Sterrett,  C.P.A.,  who  read  all  my  manu- 
script and  to  whom  I  am  tremendously  indebted.  I  am  also 
indebted  to  John  R.  Wildman,  C.P.A.,  of  the  New  York 
University,  who  also  read  my  manuscript  and  from  whom  I 
received  many  suggestions  which  I  am  sure  will  make  the 
book  more  helpful  to  students. 

The  very  comprehensive  chapter  on  Municipal  Auditing 
was  (with  very  minor  exceptions)  prepared  by  U.  L.  Leon- 


PREFACE  vii 

hauser,  C.P.A.,  Secretary  of  the  Metz  Fund  for  Promoting 
Efficient  Municipal  Accounting  and  Reporting. 

Other  suggestions  of  value  have  come  to  me  from  my 
friends  in  the  profession,  among  whom  I  must  mention 
Herbert  M.  Temple,  C.P.A.,  Waldron  H.  Rand,  C.P.A., 
George  T.  Klink,  C.P.A.,  E.  G.  Shorrock,  C.P.A.,  Seymour 
Walton,  C.P.A.,  Edward  L.  Suffern,  C.P.A.,  and  John  B. 
Geijsbeek,  C.P.A. 

Necessarily  much  of  my  work  was  done  at  irregular 
intervals,  which  meant  that  my  notes  required  careful  re- 
vision and  arrangement  This  work  was  done  for  me  by 
Gerald  van  Casteel,  Esq.,  of  the  New  York  Bar,  and  I  take 
this  opportunity  to  express  my  appreciation  of  his  able  and 
conscientious  work. 

As  my  friends  did  not  undertake  to  rewrite  all  of  my 
manuscript,  I  am  conscious  of  many  imperfections  in  the 
present  volume,  and  I  shall  gratefully  receive  any  construc- 
tive criticism  with  which  I  may  be  favored  by  those  who 
feel  enough  responsibility  in  connection  with  accountancy 
literature  to  contribute  to  another  edition  of  this  book,  which 
I  suppose  will  appear  in  the  course  of  time. 

Robert  H.  Montgomery 
55  Liberty  St.,  New  York, 

September  2,  1912. 


vi  PREFACE 

cedure  enunciated  by  Mr.  Dicksee.  More  is  now  expected 
of  the  auditor,  and,  happily,  many  of  the  profession  have 
met  this  broader  demand  and  have  shown  that  the  services 
of  the  practitioner  must  extend  over  the  whole  field  of  busi- 
ness activity.  In  view  of  these  recent  and  important  de- 
velopments, I  feel  justified  in  giving  a  subordinate  place  in 
this  work  to  what  were  formerly  regarded  as  the  chief 
objects  of  an  audit;  and  what  I  consider  to  be  the  major 
objects  of  a  modern  audit  are  discussed  exhaustively. 

It  may  be  that  I  am  too  radical  in  some  of  my  interpreta- 
tions of  the  ideal  procedure.  Perhaps  to  follow  strictly  the 
rules  laid  down  in  this  book  would  require  more  time  than 
any  auditor  is  willing  to  devote  to  a  single  engagement.  The 
exigencies  of  a  particular  case  may  make  the  opportunities 
for  investigation  more  limited  than  the  auditor  would  wish 
them  to  be.  But  the  student  and  the  young  practitioner 
particularly  should,  nevertheless,  be  careful  not  to  restrict 
the  scope  of  their  theory  and  practice  until  they  have  con- 
sidered the  last  safeguard  which  can  be  applied  to  business 
transactions  and  have  followed  up  the  slightest  hint  which 
may  throw  light  upon  any  irregularity  in  a  concern  under 
audit. 

I  would  not  have  the  courage  to  present  this  book  to  the 
profession  if  it  had  not  been  for  the  commendatory  assur- 
ances and  helpful  suggestions  of  my  partners,  William  M. 
Lybrand,  C.P.A.,  and  Walter  A.  Staub,  C.P.A.,  and  my 
friend  Joseph  E.  Sterrett,  C.P.A.,  who  read  all  my  manu- 
script and  to  whom  I  am  tremendously  indebted.  I  am  also 
indebted  to  John  R.  Wildman,  C.P.A.,  of  the  New  York 
University,  who  also  read  my  manuscript  and  from  whom  I 
received  many  suggestions  which  I  am  sure  will  make  the 
book  more  helpful  to  students. 

The  very  comprehensive  chapter  on  Municipal  Auditing 
was  (with  very  minor  exceptions)  prepared  by  U.  L.  Leon- 


PREFACE  vii 

hauser,  C.P.A.,  Secretary  of  the  Metz  Fund  for  Promoting 
Efficient  Municipal  Accounting  and  Reporting. 

Other  suggestions  of  value  have  come  to  me  from  my 
friends  in  the  profession,  among  whom  I  must  mention 
Herbert  M.  Temple,  C.P.A.,  Waldron  H.  Rand,  C.P.A., 
George  T.  Klink,  C.P.A.,  E.  G.  Shorrock,  C.P.A.,  Seymour 
Walton,  C.P.A.,  Edward  L.  Suffern,  C.P.A.,  and  John  B. 
Geijsbeek,  C.P.A. 

Necessarily  much  of  my  work  was  done  at  irregular 
intervals,  which  meant  that  my  notes  required  careful  re- 
vision and  arrangement  This  work  was  done  for  me  by 
Gerald  van  Casteel,  Esq.,  of  the  New  York  Bar,  and  I  take 
this  opportunity  to  express  my  appreciation  of  his  able  and 
conscientious  work. 

As  my  friends  did  not  undertake  to  rewrite  all  of  my 
manuscript,  I  am  conscious  of  many  imperfections  in  the 
present  volume,  and  I  shall  gratefully  receive  any  construc- 
tive criticism  with  which  I  may  be  favored  by  those  who 
feel  enough  responsibility  in  connection  with  accountancy 
literature  to  contribute  to  another  edition  of  this  book,  which 
I  suppose  will  appear  in  the  course  of  time. 

Robert  H.  Montgomery 
55  Liberty  St.,  New  York, 

September  2,  1912. 


PREFACE  TO  SECOND  EDITION 

Since  the  publication  of  the  first  edition  of  this  book  in 
September,  1912,  no  radical  changes  have  occurred  in 
theory  or  practice. 

There  has  been  a  gratifying  increase  in  the  value 
attached  to  the  certificate  of  the  professional  auditor.  With 
the  increased  responsibility  arising  out  of  such  recognition, 
there  is  observable  a  commendable  tendency  to  disclose 
upon  the  face  of  a  balance  sheet  more  information  relative 
to  financial  affairs  than  was  formerly  considered  necessary 
or  desirable. 

In  the  first  edition  the  author  repeatedly  argued  for  a 
balance  sheet  built  upon  theoretical  lines  rather  than  upon 
one  which  merely  represented  the  debits  and  credits  taken 
from  the  face  of  the  ledgers.  The  successful  auditor  must 
visualize  a  business  as  a  whole,  and  a  true  balance  sheet 
must  reflect  all  assets  and  all  liabilities,  irrespective  of  what 
are,  or  are  not,  in  the  books.  It  is  believed  that  a  careful 
study  of  an  audit  program  (which  this  book  purports  to  be) 
will  aid  the  auditor  in  his  efforts  to  set  forth  the  true  and 
full  financial  position  of  the  concern  under  audit. 

Considerable  matter  appearing  in  the  first  edition  such 
as  the  chapters  on  ethics,  legislation,  C.  P.  A.  questions, 
etc.,  has  been  omitted  in  this  edition  to  make  room  for 
new  matter  and  revision  of  old  matter  believed  to  be  of  more 
interest  and  importance. 

The  income  tax  has  come  to  stay.  Its  importance  from 
the  point  of  view  of  the  professional  auditor  cannot  be  over- 
estimated. Special  skill,  study,  and  experience  are  necessary 
to  prepare  the  returns,  and  this  means  that  in  the  future 

viii 


PREFACE 


IX 


those  most  conversant  with  the  law  and  the  procedure  there- 
under will  be  intrusted  with  the  preparation  and  super- 
vision of  returns.  It  is  hoped  that  the  rather  exhaustive 
treatment  of  the  subject  in  the  Appendix  will  be  helpful. 

In  the  absence  of  uniform  practice  and  court  decisions 
(which  alone  will  settle  many  ambiguous  parts  of  the  law), 
it  cannot  be  expected  that  the  discussion  herein  will  be 
complete  or  without  errors.  It  is,  however,  the  author's 
intention  to  revise  the  matter  from  time  to  time.  In  the 
meantime,  if  it  will  help  solve  some  of  the  present  difficulties, 
its  purpose  will  have  been  accomplished. 

The  author  takes  this  opportunity  to  thank  his  friends 
for  many  helpful  suggestions  and  criticisms. 

May  they  continue! 

Robert  H.  Montgomery 
55  Liberty  St.,  New  York, 

January  4,  1916. 


CONTENTS 


Chapter  Page 

I     Introductory -    i 

Legal  Responsibility  of  Auditors 
Summary  of  Decisions  . 

II     The   Purposes   and  Advantages   of   an 

Audit 9 

The  Purposes  of  an  Audit 
The  Minor  Objects  of  an  Audit 

1.  The  Detection  of  Fraud 

2.  The  Detection  of  Errors 

Advantages  of  an  Audit 

1.  Condition  of  Affairs 

2.  Bank  Loans 

3.  Partnerships 

4.  Fire  Loss 

5.  Bonding 

6.  Protection  of  Stockholders  and  the  Public 

7.  Sale  of  a  Business 

8.  Recovery  for  Negligence 

III     How  TO  Begin  an  Audit  ....       29 

1.  As  to  the  Client 

2.  Proper  Starting  Conditions 

3.  Co-operation  of  Client's  Staff 
Tact  Required 

4.  Compensation  Must  Depend  on  Service  Rendered 
Contingent  Fees 

5.  As  to  Where  the  Work  Is  Done 

6.  Working  Papers 
Permanent  Filing 

7.  Familiarity  with  System  in  Use 

8.  Schedules  of   Books,   Records,  and  Names  of 

Clerks 

xi 


xii  CONTENTS 

Chapter  Page 

9.  Procedure  where  Previous  Audits  Have  Been 

Made 
K).  Final    Considerations:    Detailed    or    Balance 

Sheet  Audit? 
The  Detailed  Audit 
Balance  Sheet  Audit 

Suggestions  to  Clients'  Staff  before  Commencing 
Work 

System  of  Internal  Check 

Incoming  Mail 

Cash 

Invoices  for  Purchases 

Sales  Invoices 

Customers'  Accounts 

Collections 

Pay-Rolls 

Stock  Records 

Vacations 

Branch  Store  Accounts 

IV    Balance  Sheet  Audit — Assets         .        .       59 

General  Principles 

Limitations    of    Balance    Sheet   Audits    Must   be 

Understood 
Assets 

•  Current  Assets 

Liens  and  Hypothecations 

Proportion  of  Current  Assets  to  Other  Liabilities 
and  Capital 


Cash 


Cash  in  Bank 
Cash  on  Hand 


Accounts  Receivable 

Trade  Debtors 

Miscellaneous  Receivables 

Fictitious  Accounts  Receivable 

Deposits 

Verification  of  Outstandings  by  Correspondence 


CONTENTS 

xiii 

Chapter 

Page 

V 

Balance    Sheet    Audit — Assets 

(Con- 

tinned) 

.       80 

Current  Assets  (Continued) 

Notes  Receivable 

• 

Stock  Subscriptions 

Instalment  Contracts 

Inventories 
Raw  Materials,  and  Stock  Purchased  to  be  Resold 

in  the  Same  Form 
Rules  for  Verifying  Inventories 
Goods  in  Process 
Finished  Goods 

Interest  Not  an  Element  of  Cost 
The  Turnover 
Supplies,  Stores,  etc. 
Investment  Securities 
Securities  as  Stock-in-Trade 
Temporary  Investments 
Postage  and  Other  Stamps 
Deferred  Charges  to  Operation 

VI     Balance    Sheet    Audit — Assets     (Con- 
tinued)     104 

Fixed  Assets 
Period  to  be  Covered 
Value  as  a  Going  Concern 
Land  and  Buildings 
\.  Land 
2.  Buildings 
Leaseholds 

Machinery  and  Equipment 
Small  Tools 
Furniture  and  Fixtures 
Containers 
Horses 

Wagons,  Automobiles,  etc. 
Patterns,  Drawings,  Lasts,  etc. 
Electrotypes,  Woodcuts,  etc. 
Patents 
Copyrights 


xiv  CONTENTS 

Chapter  Page 
VII     Balance    Sheet    Audit — Assets     (Con- 
tinued)     123 

Fixed  Assets  (Continued) 
Good-Will 
Sinking  Funds 
Reserve  Funds 

Fund  and  Other  Permanent  Investments 
Bonds  and  Mortgages 
Treasury  Stock 
Unissued  Capital  Stock 

Wasting  Assets 
Values  to  be  Written  Down 

1.  Mines 

2.  Timber  Land 

Contingent  Assets 
Capital  Stock  Calls  and  Assessments 
Liabilities  of  Directors 

Secret  Reserves 
VIII     Balance  Sheet  Audit — Liabilities         .     146 

Accounts  Payable 
Trade  Creditors 
Consignments 
Notes  Payable 
Mortgages 
Bonds 

Judgments  ■     . 

Interest  Payable 
Taxes 

Water  Rates,  etc. 
Wages 
Rent 
Freight 

Traveling  Expenses  and  Commissions 
Legal  Expenses 
Audit  Fees 
Damages 

Coupons,  Unused  Tickets,  etc. 
'  Deposits  ^  '         , 

Unclaimed  Dividends 


CONTENTS  XV 

Chapter  Page 
IX     Balance  Sheet  Audit — Liabilities  (Con- 
tinued)     i68 

Contingent  Liabilities 
Notes  Receivable  Discounted 
Indorsements 
Guarantees 
Acceptances 
Unfulfilled  Contracts 
The  Minute  Book 

Reserves 
Partnerships 
Partnership  Agreements 

Capital  and  Surplus 
Capital  Stock 

Premiums  on  Capital  Stock 
Sinking  Fund  Accounts 
Reserve  for  Working  Capital 
Preferred  Stock  Accumulated  Dividends,  etc. 
Surplus 
Investment  of  Surplus 

X    Profit  and  Loss  Account         .        .        .201 

Legal  Definition  of  Profits 
Economic  Definition  of  Profits 
Accountant's  Definition  of  Profits 

Earnings 
Gross  Earnings 
Returns 

Ordinary  Transactions  Only  to  be  Included 
Allowances  and  Rebates 
Bad  Accounts 
Work  in  Progress 
Departmental  Profits 
"Inter-Company  Profits" 
Sales  for  Future  Delivery 
Participations  and  Underwritings 
Profit  on  Sale  of  Assets 
Appreciation  in  Value  of  Assets 


xvi  CONTENTS 

Chapter  Page 

XI     Profit  AND  Loss  Account  (Continued)      .     219 

Expenses  and  Losses 
Reserves 
Depreciation 
Obsolescence 
Accrued  Expenses,  etc. 
Cash  Discounts 
Trade  Discounts 

Disposition  of  Profit 

Principal  and  Income 
Dividends  Must  Not  be  Paid  from  Capital 
Decedents'  Estates 
Wasting  Assets 
Interest 
Dividends 
Stock,  and  Extraordinary  Cash  Dividends 

XII     Certificates  and  Reports  .         .         .     235 

Something  More  Than  Figures  Are  Wanted  in  a 

Report 
Terminology 
Scope  of  Report 
Certificate  of  Audit 
Form  of  Balance  Sheet 
Statement  Required  by  Banks 

Standard  Form  of  Borrowers*  Statement 

Federal  Reserve  Board  Requirements 

Statement  of  Financial  Condition 

XIII     Certificates  and  Reports  (Continued)     .     268 
Statements  Requested  by  Credit  Managers 
Liens  and  Hypothecations 

Profit  and  Loss  Statement 
Use  of  Charts  and  Graphs 
Sales  Charts 

Gross  and  Net  Profit  Charts 
Combined  Purchase  and  Sales  Charts 
Preparation  of  Charts 
Value  of  Comparative  Statistics 


CONTENTS  xvii 

Chapter  Page 

What  Not  to  Report 
Restrictions  on  Client's  Use  of  Reports 
Misleading  Advertisements 
Compulsory  Reports 

XIV    The  Detailed  Audit         ....    293 

General  Principles 
Completed  Audit 
Continuous  Audit 
Auditing  by  Tests  and  Scrutiny 

The  Audit  of  Income  and  Expenses 
General  Principles 
Prior  Periods 
Verification  of  Footings  and  Postings 

1.  Purchase  Records 

2.  Sales  Records 
Controlling  Account 

Cheques  Received  Must  be  Deposited 
Periodical  Verification  of  Bank  Balances 

3.  Cash  Receipts 

4.  Cash  Payments 
Summary 

Other  Records 

XV     The  Detailed  Audit  (Continued)      .         •     313 

Verification  of  Income 
Sales 

Cash  Discounts 
Collections  Not  Accounted  for 
Confirmations  of  Outstandings 
Income  from  Investments 
Interest  Receivable 
Discount  for  Prepayment 
Trade  Discounts 
Rents  Receivable 
Realizations   from   Items   Previously  Charged  to 

Profit  and  Loss 
Consignments  and  Goods  Out  on  "Memorandum" 
Goods  Received  for  Sale 
Sales  Not  Delivered 
Sales  of  Building  Lots 


XVIU 


CONTENTS 


Chapter  Page 

XVI     The  Detailed  Audit  (Continued)      .         .     334 

Purchases  and  Expenses 
Vouchers 
Purchase  Invoices 
Missing  Vouchers 

Vouchers  for  Petty  Cash  Payments,  Pay-Rolls,  etc. 
Petty  Cash 
Organization  and  Similar  Expenses  Which  Affect 

More  Than  One  Year's  Operation 
Legal  Expenses  and  "Graft" 
Repairs  and  Renewals 
Allowances  and  Returns 
Empties 
Salaries 

Employees'  Bonds 
Salesmen's  Commissions 
Traveling  Expenses,  Entertaining,  etc. 
Wages 
Duties 
•  Interest  and  Collection  Charges 

Insurance  Premiums 
Freight  and  Express 
Postage 

Journal  Vouchers 
Purchase  Returns 
Cancellation  of  Vouchers 


XVII     The  Detailed  Audit  (Continued) 

The  Trial  Balance 
Outstanding  Accounts 
Bad  or  Doubtful  Accounts 

Asset  and  Liability  Items 
Notes  Receivable 
Notes  Receivable  Protested 
Inventories 

Premiums  and  Discounts  on  Bonds  to  be  Amortized 
Premiums  on  Capital  Stock 
Branch  Accounts 
Capital  Expenditure 
Cash  Discounts  on  Capital  Payments 


369 


CONTENTS  xix 

Chapter  Page 

Real  Estate 
Buildings 

Improvements  and  Extensions 
Machinery,  etc. 
Notes  Payable 
Partners*  Withdrawals 
Dividends 
Stock  Dividends 
Capital  Stock 
Bonds 
Taxes 

Office  Methods 

Styles  of  Books  and  Records 

Filing  Systems 

Copying 

Mailing  Department 

Stock  on  Hand 

Controlling  Subsidiary  Ledgers 

Columnar  Ledgers 

Efficiency  of  Organization 

XVIII     Depreciation 401 

Causes  for  Depreciation 

Repairs  and  Maintenance 

Methods  of  Applying  Depreciation  in  the  Books 

Sinking  Fund  Requirements  to  Retire  Bonds,  etc., 
Must  Not  be  Confused  with  Depreciation  Allow- 
ances 

Depreciation  Is  an  Operating  Expense 

Depreciation  a  Local  Issue 

Investment  of  Depreciation  Reserves 

Importance  of  Provision  for  Obsolescence 

Depreciation  of  Different  Classes  of  Property 

Land 

Buildings 

Leaseholds 

Machinery  and  Equipment 

Small  Tools 

Furniture  and  Fixtures 

Landlord's  Fixtures 

Horses 


XX  CONTENTS 

Chapter  Page 

Wagons,  Automobiles,  etc 

Ships 

Patents 

Good-Will 

Wasting  Assets 
Mines 
Timber  Lands 

XIX     Investigations 430 

Scope  of  the  Work 
Instructions  from  Clients 
Working  Papers  to  be  Preserved 
Detail  Which  May  be  Omitted 
Previous  Audits 
Where  Assets  Are  Appraised 
Definite  Report  Wanted 
Handling  Books  and  Records 
False  Entries  Sometimes  Forgeries 
Books  as  Evidence 
Loose-Leaf  Records 
Erasures 

Original  Records  Necessary 
The  Auditor  as  an  Expert  Witness 

1.  Preparation  Is  Always  Essential 

2.  A  Witness  Can  Testify  to  His  Own  Work  Only 

3.  Information  Should  Not  Be  Volunteered 

4.  Conclusions  and  Opinions 

1.    On  Sale  or  Purchase  of  a  Business 

(a)  Requirements 

Something  More  Than  Figures  Wanted 

(b)  Period  Covered 

(c)  Analysis  of  Earnings  and  Expenses 

Gross  Earnings 

Net  Earnings 

Verification  of  Sales 

The  Turnover 

Profits  on  Fluctuations 

Decrease  in  Expenses 

Advertising  and  Other  Deferred  Charges 

Leases 

Inventories 

Other  Factors  Which  Affect  Earnings 


CONTENTS  xxi 

Chapter  Page 

(d)  Future  Requirements  and  Economies 

An  Auditor  Should  Not  Prophesy 
Insufficient  Capital 
Economies  Exaggerated 
Former  Owners'  Attitude 
Competition 

(e)  System  of  Accounts 

Criticisms  Should  be  Postponed 

Condition  of  Accounts  an  Index  to  Proprietors 

Preparation  for  New  System 

XX     Investigations  (Continued)       .         .         .     469 

On  Sale  or  Purchase  of  a  Business  (Continued) 

(f)  Elimination  of  Unusual  Items 

Earnings 

Income  from  Assets  Not  Taken  Over 

Interest  on  Deposits 

Sales  of  Assets 

Appreciation  of  Assets 

Insurance  Profit 

Damages  for  Change  of  Grade,  etc. 

Expenses 

Excessive  Reserves 

Embezzlements 

Fire  and  Other  Losses  Not  Insured 

Actions  at  Law 

(g)  Adjustments  and  Qualifications 

Partners'  Salaries 

Contracts 

Taxes 

Royalties 

Orders  of  Public  Service  Commissions 

(h)  Errors  in  the  Books 

(i)  Investigations  on  Behalf  of  a  Retiring  Partner 
When  the  Business  Is  Being  Sold  to  a  Con- 
tinuing Partner 

(j)     Investigation   for  Those  in  Charge  of  Re- 
organizations 

2.    Investigation  for  Creditors,  Etc. 
Investigation  on  Behalf  of  a  Present  or  Prospec- 
tive Creditor 


xxii  CONTENTS 

Chapter  Page 

(a)  Examinations  for  Bankers 

Extension  of  Business 
Collateral  v.  Integrity 
Future  Business 
Bank  Loans  to  be  Repaid 

(b)  Investigations  After  Bankruptcy 

(c)  Investigation  for  Purely  Credit  Purposes 

Unscientific  Methods 

Lack  of  Capital 

Credit  Risks 

Insurance 

Errors  of  Principle 

Fraud 

Character 

(d)  Investigation  in  Patent  Litigation 

General  Accounting  Principles  Do  Not  Govern 

3.     Fraud 
Possibilities  to  be  Studied 
Extent  of  Fraud 
Attitude  Toward  an  Embezzler 
Definitions 

XXI     Holding  Companies  ....     508 

Consolidated  Balance  Sheets  and  Profit  and  Loss 

Statements 
Balance  Sheet 
Form  of  Balance  Sheet 
Accounts  Receivable 
Profit  and  Loss  Account 
Partial  Ownership  of  Subsidiaries 
Comparative  Statements 

XXII     Interest    .......     520 

Principal 

Rate  of  Interest 

Time 

Custom  In  Banks  and  Trust  Companies 

Custom  Among  Biisiness  Houses 

Custom  Among  Stock-Brokers 

New  York  Clearing  House 

The  Treasury  Department  of  the  United  States 

The  Unit  Period 


CONTENTS 


xxiil 


Chapter 
XXIII 


Special  Points  in  Different  Classes 
OF  Audits        .        .        .       .       . 

Introductory 

Financial 
National  and  State  Banks 

Cash  and  Securities 

Correspondents'  Accounts 

Confirmation  of  Demand  Notes,  etc. 

Certificates  of  Deposit  and  Certified  Cheques 

Capital  Stock 

Depositors'  Accounts 

Verification  of  Income 

Expenses 

Secret  Reserves 

Internal  Checks 

Scope  of  Report 

Instances  of  Fraud 
Savings  Banks 
Trust  Companies 
Investment  Companies 
Stockbrokers 

Use  of  Abbreviations 

Program  of  Audit 

Instance  of  Fraud 
Building  and  Loan  Associations 

By-Laws  and  Minute  Books 

Verification  of  Income 

Expenses 

Inspection  of  Securities 

Distribution  of  Profits 


Page 


530 


XXIV     Special  Points  in  Different  Classes 
OF  Audits  (Continued) 

Insurance 
Fire  Insurance  Companies 

Liabilities 
Life  Insurance  Companies 
Casualty,   Health,   Surety,  Title   Guarantee,  and 

Other  Companies 
Insurance  Companies  and  the  Income  Tax 


573 


XXIV 


CONTENTS 


Chapter 


Page 


Manufacturing 
Publishers  of  Books 

Publishers  of  Magazines  and  Newspapers 
Breweries 


Mining 


Coal  Mines 
Gold  Mines 


Trading 
Wholesale  Merchants 
Retail  Merchants 

Retail  Shoe  Stores 
Department  Stores 

Miscellaneous  Data  for  Retail  and  Department  Stores 
Automobile  Dealers 
Branch  Accounts 


XXV     Special  Points  in  Different  Classes 

OF  Audits  (Continued)  .        .        .631 

Public  Utilities 
Rate  Regulation 
Appraisals  of  Public  Utilities 
Steam  Railroads 
Shipping  Companies 
Electric  Railway's 
Taxicab  Companies 
Electric  Light  and  Power  Companies 
Gas  Companies 
Water  Companies 
Telephone  Companies 
Depreciation 

Special  Points  in  Different  Classes 
OF  Audits  (Continued)  .        .        .     685 

Municipal 
Preparation  of  Budget 
Fixing  the  Tax  Rate 
Authorization  of  Expenditures 
Business  Departments  of  a  City 
Sources  of  Revenue 


XXVI 


CONTENTS  XXV 

Chapter  Page 

Control  of  Receipts  and  Expenditures 
Periodical  Examinations 
Audit  of  Revenue 
Taxes 

Assessments 
Rents  and  Franchises 
Audit  of  Outstanding  Accounts 
Audit  of  Property  and  Equipment 
Audit  of  Expenditures 
Sinking  Funds 
Financial  Statements 
General  Account  Balance  Sheet 
Capital   Account   Balance   Sheet 
Trust  Fund  Balance  Sheet 
Current  Operation  and  Surplus  Account 
Fund    Balance    Sheet — General    Account 
Fund    Balance    Sheet — Capital    Account 
Summary  Consolidated  Balance  Sheet 

XXVII     Special  Points  in  Different  Classes 

OF  Audits  (Continued)  .        .        .      713 

Executors  and  Trustees 
Institutional 
Educational  Institutions 
Charitable  Organizations 
Churches 


Clubs 


Professional 


Architects 

Doctors 

Lawyers 

Miscellaneous 
Contractors 
Real  Estate 

Land  and  Development  Companies 
Hotels 
Restaurants 
Advertising  Agencies 
Theaters 
Theatrical  Companies 


XXVI 


CONTENTS 


Chapter 
XXVIII 


The  Liabilities  of  Directors 

Board  Minutes*  Inspection 
Directors'  Dealings  with  Company 
Compensation  of  Directors 
Directors  May  Inspect  Books 
Legal  Liabilities  of  Directors 


Page 
748 


Appendix — Federal  Income  Tax 


759 


Auditing — Theory  and  Practice 


CHAPTER   I 

INTRODUCTORY 

The  purpose  of  this  book  is  to  set  forth  the  principles 
underlying  the  theory  and  practice  of  auditing  and  to  outline 
the  work  which  must  be  done  in  whole  or  in  part  in 
every  audit. 

An  ideal  audit  cannot  be  made  without  a  full  perspective 
of  the  science  of  accounts,  for  many  who  have  a  good  work- 
ing knowledge  of  the  details  of  practical  accounting  find  it 
difficult  to  visualize,  as  it  were,  the  records  of  business 
transactions. 

The  auditor  who  best  accomplishes  his  task  is  the  one 
who  is  able  to  put  himself  in  the  place  of  those  for  whom 
the  accounts  are  intended,  and  he  will  not  find  this  easy 
unless  he  has  been  trained  to  make  the  most  of  the  figures 
which  appear  in  a  balance  sheet  or  profit  and  loss  statement. 
To  present  correct  accounts  is  not  enough,  because  correct 
accounts  may  not  be  clear  to  those  for  whom  they  are  in- 
tended. A  scientific  system  of  accounts  is  a  method  whereby 
a  graphic  and  intelligent  record  of  facts  may  be  assembled 
and  by  logical  processes  reduced  to  readable  form. 

Auditing  is  the  analytical,  as  practical  accounting  is  the 
constructive,  branch  of  accountancy. 

But  the  modern  auditor  is  more  than  an  analyst.  The 
logical  development  of  his  profession  and  the  increased 


2  AUDITING 

appreciation  of  the  value  of  his  work  have  added  to  his 
former  duties  certain  constructive  functions  which  must  be 
fulfilled  in  connection  with  a  large  proportion  of  his  engage- 
ments. 

The  average  business  man  has  been  trained  from  boy- 
hood to  read  facts  and  figures  from  continuous  printed 
pages.  The  trial  balance  of  a  ledger  means  nothing  to  him-, 
except  that  part  of  it  which  contains  the  accounts  receivable 
and  payable,  and  these  must  not  be  called  "Debit  Balances'* 
or  "Credit  Balances"  if  we  would  avoid  the  chance  of  being 
misunderstood. 

Many  intelligent  people  fail  to  grasp  the  usual  and  con- 
ventional hypothesis  underlying  the  theory  of  double-entry 
bookkeeping,  and  therefore  facts  or  figures  presented  to 
them  in  a  technical  or  formal  shape  may  not  accomplish 
the  intended  result.  Therefore,  the  study  of  auditing  is 
essential  to  those  who  desire  to  study  business.  It  forces 
training  in  the  fundamental  essentials  of  every  business.  It 
also  enables  a  business  man  to  know  whether  an  auditor 
whom  he  may  later  employ  is  doing  his  work  properly. 

Probably  the  majority  of  business  men  have  been  shown 
trial  balances  from  their  books  which  mean  nothing  to  them, 
and  this  applies  to  the  usual  monthly  balance  as  well  as  to  the 
one  made  after  closing  the  books.  A  balance  sheet  in  con- 
ventional form  is  perfectly  clear  to  the  eye  trained  to  read 
and  understand  figures  and  is  perhaps  as  concise  and  satis- 
factory an  exhibit  as  could  be  desired  for  the  person  who 
understands  iigures,  but  thousands  of  business  men  frankly 
acknowledge  that  they  do  not  grasp,  the  full  import  of  a 
financial  statement  in  the  accepted  form. 

But  if  the  man  who  is  entitled  to  know  all  the  facts  con- 
tained in  these  balance  sheets  cannot  or  will  not  understand 
this  method  of  presentation,  is  it  not  our  duty  to  try  another 
form  and  keep  on  trying  until  the  results  of  his  business 


INTRODUCTORY  3 

become  as  interesting  reading  to  him  as  the  daily  trade 
reports?  If  the  cHent  had  his  own  way  he  would  ask  for  a 
report  on  his  business  prepared  so  that  he  could  read  it. 

This  is  the  point  of  view  to  which  every  accountant  must 
direct  his  attention  until  he  can  so  connect  figures  and  trans- 
actions that  an  audit  will  no  longer  mean  a  mere  verification 
of  the  figures  in  the  books,  but  will  include  a  lively  apprecia- 
tion of  every  ramification  of  the  business.  In  other  words, 
the  auditor  must  visuaUze  the  transactions  themselves  to  see 
that  their  conversion  into  dollars  and  cents  is  reflected  in  the 
books  of  account. 

The  proprietor  knows  intuitively  all  of  the  possible  func- 
tions of  his  business ;  the  auditor  may  not  know  them  intui- 
tively, but  he  must  ascertain  how  and  why  the  proprietor 
looks  at  the  business  as  he  does,  otherwise  there  will  be  no 
meeting  of  minds  between  the  auditor  and  his  client.  With 
out  a  complete  understanding  of  each  other's  point  of  view 
ideal  professional  relations  can  never  be  maintained. 

There  are  many  ramifications  of  business  affairs  which 
cannot  be  understood  without  more  or  less  actual  experience 
and  technical  training,  and  which  therefore  cannot  be  satis- 
factorily elucidated  within  the  limits  of  one  book;  but  it  is 
the  firm  belief  of  the  author  that  a  common-sense  knowledge 
of  bookkeeping  and  a  general  acquaintance  with  business 
affairs  are  the  most  necessary  foundation  of  the  student  of 
auditing. 

It  is  not  expected  that  a  clerk  with  a  little  knowledge  of 
accounts  or  a  business  man  with  no  practical  experience  in 
other  lines  than  his  own  can  by  a  mere  reading  of  these 
pages  acquire  at  once  the  skill  necessary  for  the  professional 
accountant.  Nevertheless,  this  book  is  intended  for  the  in- 
struction of  those  having  but  little  experience  as  well  as  for 
the  guidance  of  the  qualified  public  accountant.  Accountancy 
is  a  science,  and  it  should  be  possible  to  present  its  underly- 


:) 


4  AUDITING 

ing  principles  so  that  they  may  be  comprehensible  to  the 
average  mind.  Theory  alone,  however,  will  never  qualify 
anyone  to  practice  as  a  public  accountant  any  more  than  a 
medical  student  is  qualified  to  practice  medicine,  no  matter 
how  thorough  a  knowledge  of  the  science  of  medicine  he 
may  have  acquired  through  lectures  and  books,  unless  he 
has  had  an  opportunity  to  verify  his  book  knowledge  and 
demonstrate  his  skill  in  the  hospital  and  the  clinic. 

If  anyone  who  proposes  to  take  up  the  study  of  auditing 
has  not  had  a  fairly  thorough  training  in  bookkeeping,  and 
in  addition  has  not  had  sufficient  practical  experience  in 
business  affairs  to  enable  him  to  keep  his  poise  when  he  is 
required  to  think  and  act  quickly,  he  had  better  postpone  his 
course  until  he  has  acquired  enough  experience  to  lay  the 
necessary  foundation. 

It  is  absurd  for  any  student  to  take  it  for  granted  that  a 
good  memory  applied  to  a  book  on  auditing  will  make  him  a 
good  auditor. 

The  work  of  the  auditor  engaged  in  public  practice  is 
important  enough  to  raise  this  work  to  the  dignity  of  a  pro- 
fession. It  has  been  called  the  profession  of  business  advice. 
Some  one  has  defined  a  profession  as  a  calling  which  de- 
mands of  its  members  a  high  order  of  intellectual  attain- 
ment, which  can  be  acquired  only  by  long  and  arduous 
preliminary  training. 

Legal  Responsibility  of  Auditors 

In  my  opinion  the  quickest  way  to  weed  out  the 
incompetent  men  who  now  hold  themselves  out  as  public 
accountants  would  be  to  make  them  understand  the  civil 
responsibility  of  a  professional  accountant.  Naturally,  an 
unreliable,  incompetent  man  cares  nothing  about  his  moral 
responsibility,  and  so  long  as  he  knows  that  American  courts 
have  never  laid  down  specific  rules  regulating  the  duties  or 


INTRODUCTORY  5 

obligations  of  public  accountants,  he  probably  feels  safe  from 
any  legal  responsibility.  One  sure  and  very  desirable  result 
of  the  weeding  out  process  would  be  the  raising  of  the 
professional  standard,  for  a  few  irresponsible  men  can  offset 
the  good  work  of  ten  times  their  number. 

As  is  well  known,  there  are  numerous  English  decisions 
dealing  with  the  rights  and  liabilities  of  professional 
auditors.  In  view,  however,  of  the  total  number  of  ac- 
countants in  practice  and  the  number  of  years  the  decisions 
cover,  the  number  does  not  seem  at  all  appalling.  While  the 
fact  that  we  have  no  reported  decisions  speaks  well  for  the 
integrity  and  good  judgment  of  our  accountants,  yet  it  is 
felt  that  occasions  have  arisen  where  a  test  case  would  have 
been  made  had  it  not  been  known  that  any  judgment  involv- 
ing money  damages  which  might  have  been  rendered  would 
have  been  worthless  so  far  as  the  possibility  of  collection  was 
concerned. 

It  is  unfortunate  that  anyone  should  be  permitted  to 
practice  as  a  public  accountant  who,  in  case  of  gross  negli- 
gence or  malpractice,  has  so  little  financial  responsibility  that 
a  judgment  against  him  would  be  worthless,  and  who,  more- 
over, is  beyond  the  legal  reach  of  his  fellow  practitioners, 
who  at  present  have  no  opportunity  to  prefer  charges  against 
one  who  is  neither  a  member  of  a  state  society  nor  certified 
by  a  state  board. 

The  absence  of  decided  cases,  however,  does  not  alter  the 
principle  of  law  that  anyone  who  holds  himself  out  to  be 
skilful  in  any  trade  or  profession,  and  who  is  negligent  in  the 
performance  of  what  he  undertakes,  becomes  responsible  in 
damages  for  such  failure.  This  civil  responsibility  is  settled 
and  cannot  be  debated,  but  it  should  not  be  passed  over 
lightly  and  should  be  emphasized  on  all  occasions.  The 
measure  of  legal  responsibility,  however,  is  much  too  low 
for  a  conscientious  accountant.  The  law  requires  of  him  only 


6         -  AUDITING 

the  skill  of  an  ordinarily  skilful  accountant;  the  law  gives 
him  the  privilege  of  assuming  the  accuracy  of  many  things 
unless  he  has  definite  suspicions  to  the  contrary,  and,  as 
already  stated,  the  law  never  requires  one  to  measure  up  to 
the  standard  of  the  most  skilful  in  the  same  profession  or 
trade.  In  this  respect  accountants  are  to  be  congratulated, 
for  it  is  common  knowledge  that  the  majority  of  professional 
accountants  in  the  United  States  seek  to  do  more  for  their 
clients  than  the  law  requires,  and  every  year  witnesses  a 
more  general  desire  to  advance  the  quality  of  services 
rendered. 

It  is  earnestly  hoped  that  further  progress  will  be  made 
in  this  direction.  Since  the  wish  for  high  standards  is 
general,  let  each  individual  accountant  do  his  part  toward 
maintaining  them.  Public  opinion  should  be  aroused  so  that 
unqualified  practitioners  will  gradually  cease  to  practice, 
and  in  their  place  a  united  certified  body  will  control  all 
accountancy  matters — not  because  the  law  grants  them  ex- 
clusive privileges,  but  by  reason  of  the  fact  that  they  can  be 
depended  upon  at  all  times  and  under  all  circumstances, 
while  the  others  cannot.* 

As  heretofore  stated,  the  State  and  Federal  courts  of  the 
United  States  appear  to  be  barren  of  any  decisions  upon  this 
important  question. 

On  the  other  hand,  both  the  common  and  statute  law  of 
Great  Britain  are  prolific  in  decisions  and  enactments,  pre- 
scribing with  much  exactness  the  precise  nature  of  the  liabili- 
ties which  an  auditor  may  conceivably  incur  while  in  the 
exercise  of  the  multifarious  activities  incident  to  his  pro- 
fession.t 

It  is  highly  probable  that  in  the  event  of  any  litigation  of 
importance  occurring  here  and  involving  that  question,  the 


*The  author  wrote  the  foregoing  article  for  the  Journal  of  Accountancy  several 
years  ago. 

tFor  English  cases  bearing  on  the  liabilities  of  auditors,  refer  to  "Auditing, 
Theory  and  Practice,"  first  edition. 


INTRODUCTORY  7 

courts  of  America  will  look  to  the  English  cases  as  affording, 
if  not  binding  precedents,  at  least  valuable  guides  to  the 
considerations  and  principles  of  law  applicable  in  such  case. 

Summary  of  Decisions 

Based  upon  the  English  decisions  and  upon  the  principles 
of  the  common  law  in  force  in  the  United  States,  the 
professional  auditor's  legal  duties  and  liabilities  may  be 
summarized  as  follows : 

1.  Anyone  who  holds  himself  out  as  skilled  in  a  profes- 
sion is  charged  with  a  higher  degree  of  responsibility  than 
one  who  is  inexperienced  and  who  does  not  seek  profes- 
sional work.  Acting  in  a  professional  capacity,  an  auditor 
must  do  more  than  ascertain  the  mere  arithmetical  accuracy 
of  the  accounts.  If  the  accounts  do  not  represent  the  true 
financial  position  of  the  undertaking  under  examination,  and 
if  that  fact  is  apparent  or  can  reasonably  be  deduced  from 
the  face  of  the  accounts  themselves,  then  the  auditor  is  under 
a  legal  obligation  to  discover  and  disclose  the  true  state  of 
affairs. 

2.  The  auditor,  however,  is  not  an  insurer  unless  he 
assumes  such  a  position.  If  he  uses  reasonable  care — the 
care  of  an  ordinarily  skilful  auditor,  under  the  circumstances 
of  the  case — no  legal  responsibility  is  incurred  by  him. 

3.  Reasonable  care  has  been  stated  by  the  courts  to 
depend  upon  the  circumstances  of  each  case.  Where  there 
is  no  reasonable  ground  for  suspicion  of  fraud,  it  is  not 
necessary  to  take  as  many  precautions  as  are  requisite  where 
the  auditor  is  led  to  believe  that  irregularities  exist. 

4.  Ordinarily  what  is  known  as  a  "test  and  scrutiny" 
audit  is  sufficient,  but  in  every  case  there  must  be  a  careful 
survey  of  the  assets,  the  liabilities,  the  income,  and  the  ex- 
penses, in  order  that  the  auditor  may  satisfy  himself  that 
the  assets  and  the  income  are  accounted  for,  and  that  the 


8  AUDITING 

liabilities  and  expenses  are  properly  supported.  The  auditor 
need  not  verify  every  item,  but  he  must  not  omit  any  part  of 
an  audit  which  the  custom  of  the  profession  decrees  should 
be  covered. 

5.  The  experience  of  other  practitioners  and  access  to 
recognized  authorities  on  the  subject  being  available,  a  de- 
fense of  ignorance  as  to  what  is  required  in  an  audit  will 
not  save  an  auditor  from  responsibility  for  failure  to  follow 
settled  rules  of  practice. 

6.  The  general  rule  of  the  common  law,  that  all  men  are 
considered  honest  until  proved  dishonest,  may  be  observed 
by  an  auditor  with  respect  to  the  staff  of  the  client ;  but  he 
is  charged  with  an  exceptional  degree  of  diligence  in  recog- 
nizing indications  of  dishonesty  on  the  part  of  those  who 
occupy  responsible  positions. 

7.  An  auditor's  relation  to  his  client  is  in  the  highest 
degree  confidential,  and  he  has  no  legal  right  to  communi- 
cate with  third  parties  (debtors  or  creditors)  unless  he 
secures  permission  to  do  so.  If  his  position  as  auditor  be- 
comes incompatible  with  honesty,  he  may  withdraw  at  any 
time,  but  he  is  not  at  liberty  to  disclose  to  outsiders  the 
cause  of  his  withdrawal. 

8.  In  communicating  with  his  client,  however,  the  auditor 
is  bound  to  disclose  information,  of  whatever  nature  it  may 
be,  which  is  of  value  to  the  client,  and  any  suppression  of 
material  facts  is  at  his  own  risk. 

9.  In  the  event  of  loss  through  an  auditor's  negligence, 
the  client  may  recover  damages  against  him.  The  measure 
of  damages  is  the  amount  which  the  client  or  other  interested 
party  has  lost  as  a  legal  consequence  of  the  auditor's  failure 
to  perform  his  duty  properly. 


I 


J 


CHAPTER    II 

THE    PURPOSES    AND    ADVANT\GES    OF    AN 

AUDIT 

The  average  business  man  is  not  familiar  with  the 
purposes  and  advantages  of  an  audit.  A  small  minority, 
have  retained  professional  auditors  and  have  gained  their 
impressions  of  what  an  audit  should  be  from  the  experi- 
ences growing  out  of  such  employment. 

Where  the  auditor  possessed  a  broad  vision  and  had 
the  advantage  of  long  and  varied  experience,  the  result 
was  a  revelation  to  the  business  man.  He  found  the 
value  received  so  greatly  exceeded  the  cost  of  the  service 
that  the  relation  became  a  continuing  one.  The  client 
advised  other  business  men  to  do  likewise,  and  so  the  prac- 
tice of  the  skilful  auditor  expanded. 

But  why  is  it  that  so  many  business  men  have  never 
availed  themselves  of  the  opportunity  to  secure  a  service 
which  has  proved  to  be  so  valuable  to  their  competitors, 
and  why  is  it  that  many  practitioners  have  not  succeeded 
in  enlarging  their  practice  during  the  last  few  years,  while 
a  considerable  number  of  auditors  have  built  up  large 
organizations  and  now  have  intrusted  to  them  a  very 
large  volume  of  work?  It  must  be  that  the  business  man 
who  does  not  employ  professional  auditors  is  ignorant  of 
the  advantages  of  an  audit,  and  that  the  would-be  auditor 
who  fails  to  secure  enough  engagements  lacks  the  full 
conception  of  the  objects  of  an  audit,  and  therefore  fails 
to  create  the  proper  impression  upon  the  clients  whom  he 
does  obtain.     It  follows  that  he  will  not  be  called  upon 

9 


lO  AUDITING 

for  subsequent  service,  and  naturally  he  is  not  recom- 
mended to  the  friends  of  his  client. 

THE  PURPOSES  OF  AN  AUDIT 

The  successful  auditor  is  the  best  medium  through 
which  the  business  public  will  gain  knowledge  of  the 
advantages  of  an  audit.  To  be  successful  the  auditor 
himself  must  have  a  thorough  and  definite  grasp  of  the 
purposes  of  an  audit. 

The  following  observations  and  suggestions  are  based 
upon  a  careful  study  of  actual  conditions  and  may  be 
relied  upon  by  the  student  as  representative  of  the  accu- 
mulated experience  of  the  auditors  who  head  the  pro- 
fession at  the  present  time. 

In  what  might  be  called  the  formative  days  of  auditing 
students  were  taught  that  the  chief  objects  of  an  audit 
were: 

1.  The  detection  or  prevention  of  fraud 

2.  The  detection  or  prevention  of  errors 

but  in  recent  years  there  has  been  a  decided  change  in  the 
demand  and  in  the  service.  That  is  to  say,  the  financiers 
and  business  men  who  origilially  retained  professional 
auditors  to  look  for  fraud  or  errors  have  enlarged  their 
demands  and  now  require  a  vastly  broader  and  more  im- 
portant class  of  work,  which  those  auditors  who  have 
advanced  in  skill  and  knowledge  have  been  able  to  under- 
stand and  perform.  We  must  therefore  relegate  the  for- 
mer "chief  objects"  to  a  subordinate  position  without  in 
any  way  depreciating  their  importance. 

The  relative  position  of  the  present-day  purposes  are: 

1.  To  ascertain  the  actual  financial  condition  and 
earnings  of  an  enterprise  for: 


ij 


I 


THE    PURPOSES    AND    ADVANTAGES  n 

(a)  Its  proprietors  (partners  or  stockholders). 

(b)  Its  executives  (managers,  officers,  or  directors). 

(c)  Bankers  or  investors  who  are  considering  the 
purchase  of  securities. 

(d)  Bankers  who  are  considering  the  discounting  or 
purchasing  of  its  promissory  notes. 

2.  The  detection  of  fraud  or  errors  as  explained  in  later 
chapters  of  this  book. 

The  results  secured  by  auditors  are  required  for  the 
following,  among  other  purposes: 

(a)  In  order  that  stock  and  bond  holders  or  other 
owners  may  have  submitted  to  them  at  regular  intervals 
a  comprehensive,  even  though  a  condensed,  statement  of 
the  financial  position  and  the  net  results  of  the  operations 
of  the  business  in  which  they  have  a  proprietary  interest, 
and  that  the  fairness  and  accuracy  in  all  essential  par- 
ticulars of  the  statement  submitted  may  be  attested  by 
means  of  a  certificate  or  report  of  a  disinterested  and 
competent  authority. 

(b)  Upon  a  proposed  sale  or  incorporation  or  other 
change  in  form  or  management,  such  as  an  attempt  to 
bring  in  additional  capital,  or  the  death  of  a  partner  or 
large  stockholder.  Matters  of  the  highest  importance 
arise  in  connection  with  the  interests  of  partners  in  the 
event  of  death  or  other  change  in  the  partnership  relations. 

(c)  To  submit  similar  statements  in  more  detail  to 
banks  and  note  brokers  as  a  basis  of  credit. 

(d)  To  submit  certified  statements  to  the  mercantile 
agencies  and  to  other  organizations  which  call  for  periodi- 
cal reports. 

(e)  To  ascertain  the  true  causes  of  fluctuations  in 
profits  or  expenses. 

•  (f)  To  state  the  facts  in  disputes  or  litigation,  and  to 


12  AUDITING 

investigate  the  causes  of  bankruptcy  for  creditors  or 
stockholders. 

This  is  a  partial  list  only  of  the  manifold  purposes  for 
which  audits  or  investigations  are  being  demanded. 

The  nineteenth  century  auditor  who  looked  chiefly 
for  fraud  or  errors  no  doubt  served  a  useful  purpose,  but 
his  methods  now  illustrate  the  history  rather  than  the 
modern  practice  of  auditing. 

Due  consideration  will  now  be  given  to  the  subject 
of  fraud  and  errors.  In  subsequent  chapters  the  present- 
day  demands  for  ''higher"  auditing  will  be  met  with  a 
full  discussion  of  the  more  important  work  of  the  profes- 
sional auditor. 

THE   MINOR    OBJECTS    OF   AN    AUDIT 

The  elementary  or  minor  objects  of  an  audit  are: 

1.  The  detection  of  fraud. 

2.  The  detection  of  errors,  and  conversely  the  pre- 

vention of  fraud  and  the  prevention  of  errors, 
particularly  of  errors  of  principle. 

The  latter,  of  course,  include  the  moral  effect  of  an 
audit,  which  extends  also  to  that  very  desirable  result 
of  keeping  the  work  of  the  office  staff  sharply  up  to  date. 
This  might  be  classed  as  a  constructive  object. 

I.  The  Detection  of  Fraud 

There  can  be  no  doubt  but  that  the  business  public 
look  upon  the  discovery  of  fraud  as  an  important  object 
to  be  attained  by  an  audit,  and  experience  has  demon- 
strated that  sufficient  fraud  has  been  so  disclosed  to  war- 
rant a  continuance  of  the  service  of  auditors  who  are 
retained  to  discover  fraud  if  it  exists. 

Gradually,  however,  the  business  man  is  being  edu- 


THE    PURPOSES    AND    ADVANTAGES  13 

cated  to  understand  that  the  discover;  of  fraud  is  one, 
and  only  one,  of  the  objects  of  an  audit,  and  by  no  means 
the  most  valuable  to  him. 

The  detection  of  fraud  is-  first  in  the  logical  presenta- 
tion of  the  objects  of  an  audit,  as  less  experience  is 
required  to  unearth  it,  and  more  definite  suggestions 
can  be  made  to  the  student  in  regard  to  it  than  is  the 
case  with  the  more  important  branches  of  the  auditor's 
duties. 

While  an  auditor  who  brings  to-  bear  all  of  his  skill 
and  resources,  and  who  leaves  no  stone  unturned  in  his 
search  for  fraud,  but  fails  to  discover  a  well-concealed 
defalcation,  is  legally  exempt  from  liability  therefor,  yet 
he  is,  and  properly  should  be,  considered  professionally 
responsible  for  such  failure,  and  his  practice  suffers  accord- 
ingly. Therefore  particular  attention  must  be  paid  to  all 
possible  avenues  which  are  open  for  the  dishonest  clerk 
or  official  who  has  an  opportunity  to  manipulate  the 
records  of  business  transactions. 

Opportunities  for  wrong-doing  vary,  as  a  rule,  with 
the  size  of  the  undertaking.  In  a  small  business  the  details 
are  apt  to  be  supervised  by  one  or  all  of  the  proprietors, 
while  in  a  large  business  much  of  the  detail  is  necessarily 
left  to  subordinates.  The  auditor  must  be  governed  by 
the  circumstances  surrounding  each  engagement  and 
then  determine  the  amount  of  detail  to  be  covered. 

(a)  Misappropriation  of  Money  or  Goods.  Usually 
fraud  consists  of  defalcations  involving  the  misappropria- 
tion of  cash,  either  by  the  failure  to  account  for  cash 
receipts  or  by  the  entry  of  payments  which  are  fictitious 
in  part  or  whole. 

In  the  following  pages  there  will  be  outlined  a  pro- , 
cedure  based  on  long  experience  which  will  disclose  such^ 
practices  in  all  ordinary  cases. 


14  AUDITING 

With  respect  to  the  misappropriation  of  assets  other 
than  cash,  a  far  more  difficult  task  is  at  hand,  but  experi- 
ence in  such  cases  has  also  permitted  the  outlining  of 
general  rules  which  will  materially  assist  the  auditor. 

(b)  Manipulation  of  Accounts  for  Other  Purposes.  The 
abstraction  of  cash  or  of  goods  is  not  the  only  reason  for 
the  manipulation  of  accounts.  The  auditor  who  has  covered 
these  two  classes  of  frauds  fully  must,  in  addition,  consider 
the  possibility  of  other  irregularities. 

In  many  undertakings  the  sources  of  cash  receipts 
and  the  disposition  of  cash  expenditures  are  so  carefully 
guarded  that  a  misappropriation  of  cash  is  almost 
impossible. 

It  is  hard  to  convince  the  business  man  whose  ac- 
counts are  so  guarded,  that  an  audit  is  of  value,  but  rely- 
ing again  on  experience,  it  has  been  demonstrated  time 
and  again  that  pecuniary  profit  in  such  cases  may  be 
^obtained  by  the  manipulation  of  records.  Usually  the 
fraud  has  been  perpetrated  by  an  official  (frequently  one 
who  has  the  entire  confidence  of  everyone)  who  has  an 
interest  in,  or  who  receives  a  bonus  based  on,  the  net 
profits  of  a  business  or  of  a  department  thereof.  In  other 
cases  the  purpose  is  to  deceive  bankers,  creditors,  or 
stockholders. 

The  auditor  must  have  all  these  purposes  constantly  in 
mind  when  determining  his  course  of  action.  If  he  does 
not  consider  all  the  elements  involved  before  commencing 
a  given  engagement,  he  may  find  at  the  end  of  a  detailed 
audit  that  a  balance  sheet  audit  would  have  enabled 
him  to  secure  satisfactory  results  in  much  less  time. 

In  discussing  hereafter  the  respective  advantages  of 
these  two  classes  of  audits,  the  author  will  endeavor  to 
assist  the  practitioner  in  the  selection  of  a  proper  line 
of  procedure. 


THE    PURPOSES    AND    ADVANTAGES 


15 


2.  The  Detection  of  Errors 

This  object  of  an  audit  does  not  receive  the  attention 
which  it  deserves,  and  the  auditor  himself  is  probably  to 
blame  for  the  present  condition  of  affairs  in  this  respect. 

During  the  time  professional  auditing  was  in  a  forma- 
tive state  in  this  country,  auditors  were  frequently  en- 
gaged to  adjust  accounts  which  had  been  badly  kept  by 
inefficient  clerks.  It  was  found  that  the  books  were  not 
in  balance,  and  that  in  order  to  adjust  them  a  vast  number 
of  en'ors  had  to  be  located  and  corrected.  In  many  cases 
this  work  consumed  months  of  time  and  a  correspondingly 
large  fee  followed.  This  was  called  ''auditing,"  but  in 
reality  it  was  accounting  work  of  the  most  elementary 
kind.  A  careful  bookkeeper  unacquainted  with  most  of 
the  principles  of  accountancy  could  have  performed  the 
service  equally  well  and  far  more  cheaply. 

This  practice  cast  more  or  less  discredit  on  professional 
auditors,  so  that  the  tendency  during  recent  years  has 
been  to  beUttle  the  importance  of  locating  errors  in  books 
of  accounts  and  to  magnify  the  advantages  of  concen- 
trating on  the  search  for  fraud  and  the  verification  of  the 
balance  sheet. 

The  author  feels  that  this  branch  of  auditing  should 
be  accorded  its  proper  place  in  stating  the  objects  of  an 
audit,  and  the  attention  of  the  student  is  particularly 
called  to  the  points  of  importance  in  the  detection  of 
errors. 

For  convenience  the  following  classification  is  made, 
involving  errors  caused  by  ignorance,  fraud,  or  mistake: 
(a)  Errors  of  Principle. 
!    (b)  Clerical  Errors 

(c)  Errors  of  Omission 

(d)  Errors  of  Commission 

(e)  Offsetting  Errors  . 


l6  AUDITING 

(a)  Errors  of  Principle.  This  is  the  most  important 
class  of  errors  and  is  one  which  the  auditor  must  never 
overlook. 

Errors  of  principle  usually  affect  both  the  profit  and 
loss  account  and  the  balance  sheet.  The  most  common 
error  is  to  debit  an  asset  instead  of  an  expense  account. 
For  instance,  an  item-  of  repairs  will  be  charged  to  build- 
ings account,  or  a  payment  covering  expenses  or  services 
will  be  charged  to  the  personal  account  of  the  payee  and 
thus  be  included  among  the  accounts  receivable,  instead 
of  being  charged  to  an  expense  account. 

Other  errprs  of  principle  do  not  affect  the  net  profit  or 
loss,  but  may  seriously  affect  the  conclusions  which  are 
drawn  from  the  various  revenue  or  expense  accounts. 
For  instance,  an  executive  may  have  determined  that  the 
advertising  appropriation  shall  be  limited  to  5  per  cent 
of  the  sales.  A  large  item  of  advertising  expense  may  be 
charged  to  some  other  expense  account  in  error,  with  the 
result  that  the  executive,  depending  upon  the  ledger  to 
give  him  the  total  expenditure,  will  authorize  additional 
advertising  and  thus  incur  an  unintentional  and  perhaps 
unnecessary  expense. 

Errors  of  principle  are  most  easily  detected  by  making 
an  intelligent  analysis  of  the  accounts  in  connection  with 
the  preparation  of  the  profit  and  loss  account  and  the 
balance  sheet. 

(b)  Clerical  Errors.  These  are  the  most  frequent  er- 
rors which  exist,  and  unfortunately  few  books  of  accounts 
are  free  from  them.  They  consist  of  errors  in  the  footings 
and  forwardings  of  the  books  of  original  entry  and 
ledgers;  errors  in  postings  other  than  those  mentioned 
under  (a),  consisting  of  postings  to  wrong  accounts  in 
the  same  class,  as  to  one  customer  or  creditor  instead  of 
another,  or  the  posting  of  an  incorrect  amount,  posting 


THE    PURPOSES    AND    ADVANTAGES 


17 


to  the  wrong  side  of  the  ledger,  or  errors  in  drawing  off 
the  trial  balance. 

These  errors  are  usually  due  to  carelessness,  but  the 
auditor  is  not  justified  in  assuming  that  accounts  in  which 
such  errors  exist  are  free  from  fraud.  He  must  differen- 
tiate between  clerical  errors  and  intentional  manipulation 
of  the  records.  A  careful  examination  must  therefore  be 
made  of  enough  of  these  errors  for  the  auditor  to  satisfy 
himself  that  they  are  bona  fide.  For  instance,  an  exces- 
sive footing  of  a  pay-roll  or  expense  account  might  be 
carelessness  or  fraud;  the  posting  of  a  greater  amount  to 
the  credit  of  a  customer's  account  than  is  shown  in  the  cash 
book  might  be  an  honest  error  in  posting  or  it  might 
indicate  an  attempt  to  conceal  a  defalcation. 

A  fair  test  of  these  errors,  however,  is  sufficient.  It  is 
no  part  of  an  auditor's  duty  (as  such)  to  locate  all  clerical 
errors,  and  the  auditor  who  devotes  a  considerable  part  of 
his  time  to  this  work  lays  himself  open  to  just  criticism.      ^ 

Auditors  lose  sight  of  the  fact  that  the  closing  of  \ 
books  and  the  resulting  balance  sheets  are  based  on  esti-__y 
mates  only.  Some  auditors  spend  many  hours  in  adjusting 
balance  sheet  items  in  order  to  correct  a  few  trifling  errors, 
when  there  are  valuations  of  hundreds  of  thousands  of 
dollars  in  plant,  merchandise,  stocks,  etc.,  all  of  which 
are  necessarily  estimates  and  which  fluctuate  from  day  to 
day — as  must  the  value  of  all  materials  and  goods.  So 
long,  therefore,  as  small  errors  in  calculations,  extensions, 
etc.,  do  not,  relatively  speaking,  actually  affect  the  balance 
sheet,  time  should  not  be  wasted  on  such  adjustments. 

(c)  Errors  of  Omission.  An  auditor  is  justified  in 
spending  more  time  in  looking  for  errors  of  omission 
than  in  connection  with  any  other  class  of  errors.  Where 
the  internal  check  (see  page  53  et  seq.)  is  not  perfect, 
the   utmost    care   must   be   taken   to  verify   all   possible 


l8  AUDITING 

sources  of  revenue  to  ascertain  whether  or  not  all  such 
items  are  entered  in  the  books.  Errors  of  omission  usu- 
ally do  not  affect  the  trial  balance  and  are,  therefore,  not 
detected  automatically.  They  are  distinguished  from  the 
class  of  errors  where  items  are  not  posted  at  all,  as  with 
these  (except  where  both  sides  of  a  journal  entry  are  not 
posted)  the  trial  balance  is  affected  and  the  usual  checking 
back  of  the  postings  would  locate  the  differences. 

Instances  of  errors  of  omission  are  as  follows:  Goods 
may  be  delivered,  but  not  billed;  rent  may  not  be  charged 
or  collected.  On  the  other  hand,  purchases  may  be  made 
and  the  goods  received,  but  the  invoices  for  same  may 
not  be  entered  in  the  books.  In  order  to  cover  this  class 
of  errors,  the  auditor  should  locate  all  books  of  original 
entry,  whether  so-called  memorandum  books  or  other 
informal  records,  then  a  fair  selection  of  items  should  be 
traced  into  the  regular  books  of  account.  If  the  test 
does  not  disclose  any  material  differences,  it  may  be  as- 
sumed that  the  records  are  accurate.  If  the  test  should 
disclose  one  or  more  errors  of  sufficient  size  to  affect  the 
results  favorably  or  unfavorably,  a  more  extensive  test 
should  be  made.  It  might  be  well,  however,  before  ex- 
tending the  verification  to  request  authority  for  so  doing 
from  the  client. 

In  an  examination  of  the  accounts  of  a  publisher  the 
auditor  compared  the  advertisements  appearing  in  one 
issue  of  a  popular  magazine  with  the  book  in  which 
charges  to  advertisers  were  entered.  It  was  found  that 
an  insertion  of  a  full  page  had  not  been  charged  for.  The 
item  was  billed  and  collected.  Thereupon  the  other 
eleven  issues  were  carefully  checked,  but  no  other  omis- 
sion was  found. 

If  the  auditor  names  a  fixed  fee  for  an  audit,  it  is 
always  well  to  state  that  tests  only  will  be  made.     If  an 


THE    PURPOSES    AND    ADVANTAGES 


19 


error  is  discovered  in  the  test,  the  auditor  has  fulfilled 
his  agreement  and  need  not  go  further  unless  an  addi- 
tional fee  is  arranged  for.  If  he  will  broach  the  subject 
as  soon  as  the  test  is  completed  there  will  probably  be  no 
difficulty  in  securing  an  extra  allowance,  but  if  no  refer- 
ence is  made  to  his  purpose. to  charge  extra  for  additional 
work,  he  will  usually  have  difficulty  in  collecting  anything 
at  all  additional,  no  matter  how  many  or  how  few  errors 
are  brought  to  light. 

(d)  Errors  of  Commission.  These  occur  chiefly  in 
connection  with  the  books  and  records  of  original  entry 
and  consist  of  items  which  are  incorrectly  recorded,  either 
in  whole  or  in  part. 

*For  instance,  an  entry  in  the  sales  book  may  be  incor- 
rect as  to  quantities,  or  in  the  extension  of  the  items. 
These  errors  do  not  affect  the  trial  balance  and  frequently 
remain  undetected. 

The  same  tests  as  are  recommended  under  (c)  above 
should  be  followed,  except  that  it  is  not  usually  necessary 
to  cover  as  many  items.  Calculations  of  purchase  and 
sales  items  are  frequently  verified  by  two  persons  in  the 
offices  where  they  originate,  and  almost  invariably  are 
checked  in  the  offices  to  which  they  are  sent. 

The  test,  therefore,  may  be  extremely  limited,  pro- 
vided it  is  apparent  that  care  is  taken  by  the  clerks  in 
charge  of  such  work. 

(e)  Offsetting  Errors.  These  occur  fairly  often,  and 
while  they  could  be  classed  under  the  other  headings 
mentioned,  they  are  dangerous  enough  to  deserve  special 
mention. 

An  offsetting  error  is  one  which  is  counterbalanced 
by  another  error  or  errors.  It  is  an  annoying  type.  As 
one  error  may  occur  in  an  asset  or  liability  account  and 
the  other  in  an  expense  or  income  account,  an  auditor  is 


20  AUDITING 

not  justified  in  passing  any  accounts  until  satisfied 
that  such  errors  do  not  exist.  Of  course,  this  does 
not  mean  the  verification  of  every  posting,  but  it  does 
call  for  the  tests  or  analyses  described  more  fully 
hereafter. 

Few  executives  realize  the  great  number  of  clerical 
errors  v^hich  are  made  every  day.  Perhaps  these  are 
mxOst  numerous  in  banks,  brokers'  offices,  and  other  of^ces 
where  the  accounts  are  balanced  daily.  An  immense 
amount  of  work  is  accomplished  in  a  short  space  of  time. 
Clerks  work  at  high  pressure,  and  knowing  that  there 
will  be  a  check  on  their  work  before  they  leave  at  night, 
they  do  not  verify  their  entries  as  they  go  along,  as  is 
the  case  with  many  clerks  who  depend  on  the  monthly 
trial  balance  to  detect  their  errors.  Consequently  a 
great  number  of  errors  are  made,  but  as  soon  as  it  is  found 
that  the  day's  work  must  be  checked  back,  they  are  located 
and  corrected.  Many  of  these  errors  are  of  $10,  $100, 
or  $1,000.  Therefore  it  is  not  strange  if  two  errors  of 
the  same  amount  should  be  made  on  the  same  day  in  dif- 
ferent departments,  so  that  the  accounts  for  that  day 
actually  balance  in  spite  of  the  two  errors. 

Recently  the  author  was  called  in  by  the  senior  partner 
of  a  large  stock  exchange  house  who  was  greatly  troubled 
over  the  fact  that  two  errors  of  $100  each  had  been 
made  on  a  certain  day  and  had  remained  undetected  for 
three  weeks.  He  felt  that  something  was  wrong  with  the 
system  of  accounts  or  with  his  clerks;  he  could  not  decide 
which.  He  was  advised  that  the  discovery  and  reporting 
of  the  mistake  by  the  only  clerk  who  could  have  benefited 
by  it  indicated  that  fraud  was  not  intended,  but  that  if  a 
similar  case  arose  soon  again,  a  fuller  investigation  should 
be  made. 

The  rule,  therefore,  is  that  an  offsetting  error  may 


THE    PURPOSES    AND    ADVANTAGES  ^I 

occur  at  any  time,  but  that  the  law  of  averages  wx>uld 
operate  against  much  duplication. 

ADVANTAGES  OF  AN  AUDIT 

An  auditor's  duty  is  to  discover  and  disclose  the  truth 
about  accounts,  but  this  is  too  general  a  designation  of 
his  duties  to  use  when  confronted  with  a  specific  case. 
Furthermore,  the  business  world  must,  for  many  years  to 
come,  be  educated  up  to  a  proper  appreciation  of  an 
accountant's  functions,  so  the  present-day  auditor  must 
be  a  teacher  as  well  as  an  adviser.  He  must  be  prepared 
to  explain  the  purpose  of  his  work  and  set  forth  clearly 
the  objects  to  be  attained  as  the  result  of  his  labors. 

The  professional  auditor,  therefore,  must  give  the  im- 
pression of  having  a  scope  and  purpose  far  in  advance  of 
the  old-time  auditor,  whose  work  was  chiefly  confined  to 
ascertaining  whether  the  accounting  party  had  properly 
recorded  all  receipts  and  payments  on  behalf  of  his  prin- 
cipal. In  fact,  the  old-fashioned  audit  was  a  cash  audit. 
A  modern  audit,  however,  although  it  includes  the  exami- 
nation of  cash  transactions,  has  as  its  ultimate  purpose 
the  verification  of  the  balance  sheet. 

An  auditor  should  be  prepared  to  state  that  he  must 
make  such  an  examination  of  the  books  and  records  of 
the  undertaking  as  will  enable  him  to  satisfy  himself 
whether  or  not  the  balance  sheet  is  properly  drawn  up 
so  as  to  exhibit  a  true  and  correct  record  of  its  financial 
affairs. 

An  auditor  who  has  not  himself  a  clear  idea  of  the 
value  or  advantages  of  an  audit  can  hardly  expect  to 
impress  his  client  as  to  his  purpose. 

The  chief  advantages  are,  of  course,  identical  with  the 
main  purposes  of  an  audit.  The  minor  objects,  viz.,  that 
fraud  will  be  disclosed  if  it  exists;  that  technical  errors. 


22  AUDITING 

if  any,  will  be  discovered  and  corrected;  that  errors  of 
principle,  if  they  exist,  will  be  detected,  and  the  means  of 
preventing  their  repetition  in  the  future  pointed  out, 
have  been  discussed. 

The  major  advantages  which  have  been  mentioned 
may  now  be  enlarged  upon. 

1.  Condition  of  Alffairs 

An  accurate  statement  of  affairs,  together  with  a  profit 
and  loss  account,  showing  how  this  position  was  reached, 
is  prepared  by  a  disinterested  expert.  In  a  vast  number 
of  cases  this  statement  by  the  auditor  is  the  first  accurate 
information  which  the  client  has  ever  had  as  to  his  own 
condition. 

Left  alone,  a  business  man  seems  to  love  to  fool  him- 
self; so  he  goes  along,  year  after  year,  overstating  his 
assets,  overlooking  depreciation,  and  forgetting  his  liabili- 
ties. A  correct  balance  sheet  made  up  by  a  professional 
auditor  brings  him  sharply  to  time.  It  will  never  be 
known  how  many  enterprises  have  been  saved  from  ulti- 
mate failure  through  the  presentation  of  unwelcome  facts 
by  an  auditor  who  cannot  and  will  not  be  influenced 
by  former  inaccurate  statements  of  condition. 

2.  Bank  Loans 

Certified  accounts  are  particularly  valuable  as  a  basis 
for  bank  loans.  All  leading  bank  managers  recognize  the 
assistance  rendered  to  them  in  the  course  of  their  busi- 
ness by  public  accountants,  and  even  if  a  business  man  is 
in  the  happy  position  of  not  requiring  occasional  aid  from 
his  banker,  yet  his  financial  rating  is  considerably  higher 
if  he  is  thoroughly  up-to-date  in  the  care  of  his  books 
and  accounts. 

The  extension  of  credit  by  a  bank  depends  on  the 
judgment  of  its  officers  as  to  the  ability  of  the  borrower 


THE    PURPOSES    AND    ADVANTAGES 


23 


to  repay  the  loan  when  due.  The  auditor,  by  reason  of  his 
independence,  is  able  to  assist  the  banker  in  forming-  his 
judgment.  The  prospective  borrower  cannot  view  the 
condition  of  his  own  business  without  bias.  The  bor- 
rower expects  to  postpone  the  time  of  payment  and  there- 
fore anticipates  a  future  condition  more  satisfactory, 
doubtless,  than  is  the  case  at  the  time  of  the  application. 
The  auditor  must,  in  a  measure,  pass  on  the  probability 
and  the  possibility  of  the  future  in  the  light  of  past  results. 

This  does  not  excuse  an  auditor  who  estimates  a  defi- 
nite profit  in  the  future,  out  of  which  a  bank  loan  will  be 
paid,  but  it  do€S  support  the  recent  statements  of  promi- 
nent bankers  that  the  services  of  professional  accountants 
are  becoming  of  increasing  value  to  them,  largely  because 
they  are  able  to  report  orally  the  result  of  their  "sizing  up" 
of  the  borrower  or  the  prospective  borrower. 

If  an  auditor  refrains  from  expressing  any  oral  opinion 
on  the  probabilities  of  the  future  of  a  business  the  ac- 
counts of  which  he  has  just  subjected  to  the  most 
thorough  analysis  and  scrutiny,  it  is  possibly  because  he 
relies  upon  the  ancient  fiction  that  an  accountant  deals 
with  facts  only,  and  that  future  results  are  not  facts;  or 
perhaps  he  is  afraid  to  express  his  own  convictions. 

If  he  finds  that  he  is  usually  rig^ht  in  his  forecast  of 
future  business,  it  would  seem  only  fair  that  his  conclu- 
sions should  be  communicated  to  his  client  at  the  time 
they  are  formed. 

It  is  an  unquestioned  advantage  for  any  borrower  to 
be  able  to  comply  with  the  requirements  of  the  banker 
or  note  broker  to  whom  he  applies  for  a  line  of  credit. 
The  attention  of  a  prospective  client,  may,  therefore,  be 
properly  drawn  to  the  official  action  of  the  supreme  body 
of  American  bankers. 

At  the  Convention  of  the  x^merican  Bankers'  Associa- 


24 


AUDITING 


tion,  held  at  Denver,  Colo.,  in  1908,  the  Committee  on 
Credit  Information  reported,  urging  ''that  every  member 
exert  his  influence  to  have  all  paper  purchased  from  note 
brokers  presented  with  accompanying  statements  audited 
by  Certified  Public  Accountants  ...,,"  and  to  that  end 
asked  that  the  Association,  by  the  adoption  of  the  Com- 
mittee's report,  ''recommend  that  its  members,  in  pur- 
chasing commercial  paper  from  note  brokers,  give  pref- 
erence to  such  names  as  furnish  accompanying  statements 
audited  by  Certified  Public  Accountants." 

Prominent  bankers,  from  time  to  time,  have  urged 
their  associates  in  conventions  and  elsewhere  to  require 
all  prospective  borrowers  to  furnish  certified  statements. 

Unfortunately,  competition  in  banking  circles  is  still 
too  keen  to  permit  this  rule  to  be  adopted.  Some  recent 
large  losses  by  banks,  arising  out  of  gross  overvaluations 
of  assets  and  understatements  of  liabilities  on  the  part 
of  borrowers,  may  incline  them  to  require  certified  state- 
ments by  impartial  accountants. 

3.  Partnerships 

Partnership  books  should  always  be  adjusted  by  a 
professional  accountant  if  for  no  other  reason  than  that 
he  will  act  impartially  and  comply  fully  with  the  articles 
of  copartnership.  These  accounts  are  peculiarly  liable  to 
disturbances  by  causes  from  which  corporations  on  the 
whole  are  exempt.  Disputes  occur  as  to  salaries,  division 
of  profits,  partner's  overdrawings,  inattention  to  business, 
and  many  other  things  which  would  to  a  large  extent  be 
obviated  if  the  books  were  regularly  audited  by  a  com- 
petent outsider.  A  partner  dies  and  there  is  trouble  with 
his  administrator  as  to  the  division  and  withdrawal  of  the 
decedent's  capital,  in  many  cases  resulting  in  expensive 
lawsuits  and   the   permanent   crippling   of   the   business. 


THE    PURPOSES    AND    ADVANTAGES 


25 


A  partnership  goes  into  bankruptcy,  perhaps  through 
misconduct  of  a  trusted  partner.  Had  a  continuous  audit 
been  in  force  the  fraud  might  have  been  nipped  in  the  bud. 
Again,  for  the  protection  of  a  limited  or  special  partner 
and  a  silent  or  dormant  partner  a  periodical  independent 
audit  is  essential. 

4.  Fire  Loss 

In  the  case  of  loss  of  merchandise  by  fire,  a  properly 
authenticated  balance  sheet  prepared  by  a  public  accoun- 
tant is  a  material  aid  in  the  adjustment  of  claims.  This 
is  not  a  theory;  it  has  been  demonstrated  in  practice.  All 
business  men  anticipate  the  possibility  of  a  fire,  but  few 
of  them  consider  just  how  they  will  collect  their  insurance. 

During  the  progress  of  an  audit  the  auditor  will  ascer- 
tain the  methods  of  bookkeeping  in  force,  and  whether, 
in  case  of  fire,  the  records  would  be  properly  protected. 
He  will  ascertain  if  a  perpetual  inventory  be  maintained, 
or  whether  it  would  be  necessary  to  calculate  the  amount 
of  the  loss  upon  the  usual  basis,  that  is,  to  take  the  last 
recorded  inventory,  add  purchases  to  date  of  fire  and 
deduct  cost  of  goods  sold,  the  result  being  the  stock  on 
hand  at  time  of  fire. 

The  cost  of  goods  sold  is  ascertained  by  deducting 
from  the  sales  the  average  gross  profit  realized  in  prior 
periods.  Fire  insurance  adjusters  are  shrewd  and  experi- 
enced and  the  business  man  whose  records  are  in  poor 
order  is  usually  forced  to  settle  upon  a  basis  satisfactory 
to  the  adjuster.  If  the  business  man's  accounts  are  in 
good  shape  and  he  can  show  that  the  last  inventory  had 
been  certified  to,  he  can  decline  to  compromise  and  insist 
on  the  full  amount  of  his  claim  being  allowed. 


5.  Bonding 

A  cashier  whose  books  are  audited  regularly  has  little 


26  AUDITING 

trouble  in  securing  a  good  company  to  act  as  surety  for 
him;  in  fact,  several  of  the  best  companies  insist,  as  part 
of  the  contract,  that  this  be  done  periodically. 

6.,  Protection  of  Stockholders  and  the  Public 

The  interests  of  the  real  proprietors  of  a  business  (the 
stockholders  in  the  case  of  a  corporation)  should  be  pro- 
tected in  every  feasible  and  reasonable  manner.  One  way 
in  which  such  an  end  might  be  served  would  be  to  con- 
form to  the  English  method.  There  stockholders  elect 
at  the  annual  meeting  a  professional  accountant  as  the 
auditor  of  the  company  for  the  ensuing  year,  and  his 
report  is  made  to  the  stockholders  and  not  to  the  officers 
and  directors. 

A  corporation  which  has  nothing  to  hide  cheerfully 
sends  its  balance  sheet  out  to  its  stockholders,  and  if  the 
latter  exhibit  enough  interest  in  the  matter  to  request 
that  the  certificate  of  a  professional  auditor  be  attached, 
such  request  will  probably  be  complied  with.  Therefore, 
in  every  possible  and  dignified  way  the  auditor  should 
impress  upon  stockholders  the  many  advantages  to  them- 
selves of  such  procedure. 

The  value  of  the  publicity  of  audited  accounts  cannot 
be  overestimated.  In  a  general  way  all  corporations  are 
believed  to  be  making  unreasonable  profits,  particularly 
all  corporations  which  in  any  way  attempt  to  serve  the 
public. 

For  instance,  in  New  York  City,  the  taxicab  com- 
panies have  been  attacked  in  the  newspapers  and  one 
ordinance  after  another  has  been  passed  regulating  fares, 
all,  of  course,  reducing  them.  In  a  few  years  at  least  two 
millions  of  dollars  were  lost  by  three  or  four  of  thest 
companies.  During  this  time  they  did  not  make  per! 
odical  statements  to  their  stockholders  nor  to  the  publi^ 


THE    PURPOSES    AND    ADVANTAGES 


27 


setting  forth  these  losses  and  the  reason  therefor.  For 
some  mysterious  reason  pubUcity  was  shunned. 

It  is  about  as  certain  as  anything  can  be  that  if  certi- 
fied statements  of  operations  had  been  secured  and  sent 
to  the  newspapers  annually,  a  far  different  state  of  public 
opinion  would  have  resulted. 

Corporations  which  are  secretive  about  their  accounts 
or  which  issue  statements  not  certified  to,  have  only 
themselves  to  blame  if  they  are  made  the  victims  of  hostile 
legislation. 

7.  Sale  of  a  Business 

The  author  has  had  several  experiences  in  which  it 
was  demonstrated  that  if  periodical  statements  of  the 
results  of  operations  duly  certified  to  by  responsible 
auditors  had  been  available,  large  enterprises  would  have 
changed  hands  in  a  few  days,  but  such  statements  not 
being  promptly  available,  the  sales  were  not  made. 

In  one  case  the  president  of  a  corporation  in  which  he 
owned  a  controlling  interest  was  offered  two  and  a  half 
million  dollars  for  control,  subject  to  examination  by 
accountants.  He  accepted.  When  an  attempt  was  made 
to  ascertain  the  earnings  for  a  period  of  years  it  was  found 
that  no  accurate  records  had  ever  been  kept.  Large 
profits  had  been  realized,  but  the  only  reason  this  v/as 
known  was  because  the  money  was  in  the  bank.  Physical 
inventories  had  never  been  taken  and  book  inventories 
had  not  been  kept.  At  the  time  of  the  proposed  purchase 
the  plant  was  operating  on  an  extensive  scale,  but  as  no 
cost  records  were  kept,  it  was  impossible  to  determine 
the  rate  of  profit  on  the  current  output.  The  deal  was 
called  ofif. 

The  president  complained  bitterly.  He  had  paid  enor- 
mous dividends,  which  he  knew  had  been  earned,  but  no 


28  AUDITING 

one  could  determine  just  when  and  how  they  were  real- 
ized, and  the  condition  of  the  accounts  cast  suspicion  on 
the  whole  enterprise. 

Practically  all  business  men  look  forward  to  retiring 
sooner  or  later.  It  is  a  kindness  to  them  to  indicate  how 
much  easier  and  more  certain  it  will  be  for  them  to  accom- 
plish their  purpose  if  they  can  produce  correct  certified 
accounts  than  to  depend  upon  unaudited  accounts,  which 
may  fail  to  meet  the  requirements  of  a  prospective 
purchaser. 

8.  Recovery  for  Negligence 

The  final  advantage  of  an  audit  (and  one  upon  which 
perhaps  serious  differences  of  opinion  may  exist  as  to  the 
advisabiUty  of  public  discussion)  is,  that  a  client  who 
may  suffer  loss  through  the  dishonesty  of  an  employee 
may  recover  an  equivalent  amount  from  the  auditor,  pro- 
vided that  the  latter  is  shown  to  have  performed  his 
work  in  a  grossly  negligent  manner,  and  provided,  of 
course,  that  the  defalcation  occurred  during  the  period 
covered  by  the  audit  and  continued  thereafter. 


I 


CHAPTER    III 

HOW  TO  BEGIN  AN  AUDIT 

The  importance  of  knowing  how  to  begin  an  audit  can- 
not be  overestimated.  Until  the  business  pubHc  is  educated 
to  a  point  where  it  knows  just  what  is  required  and  can  ask 
for  specific  service,  which  in  turn  the  auditor  can  perform 
without  violating  his  rules  of  practice,  his  employment  is 
more  or  less  general  in  its  nature  and  the  scope  of  the  work 
is  left  to  the  auditor. 

For  this  reason  many  practitioners  commence  the  work 
before  they  have  a  clearly  defined  line  of  procedure  in  their 
own  minds. 

Based  on  personal  experiences  of  over  twenty-five  years, 
the  author  suggests  the  following  preliminary  program : 

I.  As  to  the  Client 

Uncertainty  sometimes  exists  as  to  the  actual  client 
whom  the  auditor  is  serving,  to  whom  he  is  responsible,  and 
as  to  who  will  pay  the  bill.  It  may  be  a  banker  or  a  prospec- 
tive borrower,  a  corporation  or  a  dissatisfied  stockholder, 
a  trustee  in  bankruptcy  or  the  petitioning  creditors,  or  a 
creditors'  committee,  a  municipality  or  an  aldermanic  com- 
mittee, a  state  or  an  investigating  committee  of  the  legisla- 
ture. In  all  of  these  cases  and  many  more,  differences  of 
opinion  have  arisen  as  to  the  legal  status  of  the  client ;  there- 
fore, this  word  of  caution  addressed  particularly  to  the 
beginner  is  in  order : 

Fix  the  legal  status  of  the  client  before  work  is  com- 
menced. 

29 


30 


AUDITING 


2.  Proper  Starting  Conditions 

Some  auditing  engagements  have  ended  disastrously  for 
the  auditors  because  the  work  was  undertaken  Mindly.  It 
is  not  enough  that  some  one  should  say,  ''Here  are  certain 
books  and  records ;  I  want  them  audited  and  a  report  made 
to  me  of  what  they  contain."  The  client  may  thmk  he  knows 
what  he  wants,  he  may  be  financially  able  to  pay,  and  to  a 
young  practitioner  the  temptation  to  jump  in  and  follow 
instructions  is  strong  indeed.  But  the  client  may  and  does 
change  his  mind  as  the  work  progresses,  and  even  if  the 
instructions  are  in  writing,  he  will  find  some  excuse  for  his 
change  of  mind.  He  may  still  be  able  to  pay,  but  he  may 
not  want  to.  There  are  several  notable  examples  of  work 
done  along  the  lines  indicated  th-e  bills  for  which  have  never 
been  paid. 

Therefore,  spend  some  time  with  the  client,  reviewing  the 
work  before  it  is  commenced.  Map  out  as  definite  a  program 
as  possible  and  overstate,  rather  than  understate,  the  prob- 
able time  which  will  be  required.  The  client  may  have  a 
vague  knowledge  of  details,  but  he  should  know  pretty  well 
what  the  work  should  cover,  and  if  the  auditor  cannot  come 
to  a  fairly  definite  agreement  with  him  as  to  the  scope  and 
extent  of  the  work,  the  responsibility  of  making  good  is 
placed  definitely  on  the  auditor. 

A  few  hours'  talk  of  this  nature  may  subsequently 
eliminate  many  days  of  useless  work — useless  because  there 
may  have  been  a  mistaken  idea  as  to  the  results  wanted ;  or 
the  results  striven  for  might  be  very  valuable  and  interesting 
if  the  work  could  be  completed  as  originally  planned. 

In  most  cases  the  auditor's  wide  experience  enables  him 
to  know  better  than  the  client  just  what  should  be  done,  and 
what  may  be  safely  omitted,  but  this  does  not  relieve  an 
auditor  from  his  obligation  to  assure  himself  whether  in  the 
particular  case  before  him  the  client's  intimate  knowledge 


HOW    TO    BEGIN    AN    AUDIT  3I 

of  the  business  does  not  justify  him  in  indicating  the  general 
lines  along  which  the  audit  should  be  made. 

A  full  and  frank  talk  with  a  client  cannot  do  any  possible 
harm  and  may  insure  co-operation  and  harmony,  which 
might  be  lacking  if  the  auditor  shows  too  much  of  a  disposi- 
tion to  run  the  whole  job  himself. 

3.  Co-operation  of  Client's  Staff 

A  successful  auditor  told  the  author  recently  that  in 
every  audit  he  endeavored  to  attract,  instruct,  and  convert 
the  office  stafif,  and  in  so  doing  he  not  only  rhade  his  own 
work  pleasanter  and  more  satisfactory  in  a  professional  way, 
but  that  he  made  them  co-workers  with  him,  and  in  many 
ways  they  aid  the  growth  of  a  proper  opinion  of  the  value 
of  the  pubHc  accountant.  Many  instances  are  known  where 
auditors  have  antagonized  an  office  staff  and  sent  them  out 
to  an  extensive  acquaintance  charged  with  a  desire  to 
criticize  most  unfavorably  not  only  the  offending  auditor 
(which  would  not  be  unfair),  but  also  professional  auditors 
as  a  class. 

Some  very  large  engagements  have  resulted  directly 
from  a  word  of  commendation  to  others  from  a  bookkeeper 
or  clerk  who  has  had  a  satisfactory  experience  with  the 
auditor  of  his  accounts. 

All  auditors  of  experience  agree  that  the  majority  of 
men  are  honest — not  a  mere  majority  only,  but  most  men 
are  honest.  Furthermore,  most  men  are  sensitive  about  hav- 
ing their  honesty  questioned  even  indirectly.  The  successful 
auditor  does  not  conduct  himself  in  such  a  manner  as  to 
indicate  to  anyone  that  suspicion  exists.  He  must  radiate 
his  belief  in  the  good  faith  and  honesty  of  purpose  of  those 
whose  accounts  he  is  examining;  but  he  will  be  none 
the  less  thorough  and  he  will  just  as  surely  land  any  guilty 
man. 


32 


AUDITING 


The  honest  man  is  also  sensitive  to  criticism  of  his  work. 
Here  the  auditor's  task  is  harder,  because  the  duty  to  one's 
cHent  must  be  placed  above  everything  else,  and  while  it  is 
sometimes  unpleasant  to  condemn  carelessness  and  mistakes 
on  the  part  of  the  office  staff,  yet  if  it  is  evident  that  the 
client's  business  is  suffering  therefrom,  failure  to  report 
actual  conditions  would  be  a  breach  of  professional  duty. 

But  the  auditor  who  prepares  his  report  and  sends  it  in 
to  the  client  without  considering  its  effect  on  the  office  staff 
may  be  doing  a  positive  injury  to  his  client  as  well  as  to 
himself.  The  clerk  whose  work  is  criticized  may  be  one 
of  the  most  valuable  on  the  staff.  His  merits  m.ay  vastly 
outweigh  his  shortcomings,  yet  if  he  is  sensitive  he  may 
resign  forthwith,  thus  weakening  the  client's  organization 
and  subjecting  the  auditor  to  the  wrath  which  he  in  a 
measure  deserves. 

Or  again,  the  clerk  or  clerks  whose  work  is  criticized 
may  not  resign,  but  being  in  the  confidence  of  the  client  and 
having  his  ear  every  day,  may  easily  offset  all  of  the  good 
effect  which  the  criticisms  and  suggestions  might  have, 
and,  in  addition,  prejudice  the  client  against  the  further 
employment  of  the  auditor. 

Naturally,  the  auditor  is  not  informed  as  to  what  is 
taking  place,  and  if  his  services  are  not  called  for  when 
another  audit  is  due,  he  is  ignorant  of  the  true  reason  for 
the  decision  against  him. 

Hundreds  of  business  men  have  retained  a  professional 
auditor  once  as  an  experiment,  because  they  had  been  told 
it  was  the  proper  thing  to  do,  and  would  have  become  regular 
clients  had  the  auditor  been  able  to  secure  the  sympathy  and 
co-operation  of  the  office  staff. 

Who  can  blame  a  busy  man,  necessarily  dependent  upon 
an  organization  of  trusted  employees,  for  heeding  their 
opinion  of  an  auditor. 


4 


HOW    TO    BEGIN    AN    AUDIT  23 

Tact  Required 

The  auditor  need  not  stultify  himself  by  failure  to 
criticize.  As  a  matter  of  fact,  an  honest  staff  resents  gratuit- 
ous commendation  if  fthey  know  it  is  not  deserved.  All  they 
want  is  a  square  deal.  In  practically  all  cases  the  methods  in 
force  were  initiated  by  the  client  himself  or  by  the  predeces- 
sors of  the  present  staff.  They  are  simply  following  pre- 
cedents or  instructions  and  should  not  be  personally  blamed 
for  unsatisfactory  methods  or  results. 

Let  the  auditor  proclaim  his  gospel  of  helpfulness  and 
ask  for  co-operation  in  the  interest  of  the  staff  and  in  that 
of  the  client.  Let  him  demonstrate  quietly  that  he  knows 
more  than  they  do,  but  let  it  be  done  unobtrusively.  Show 
them  that  failure  to  be  up  to  date  is  detrimental  to  success, 
and  that  modern  methods  must  justify  themselves.  Get 
them  interested  and  ask  their  help  in  preparing  an  unbiased 
report  on  actual  conditions,  and  obtain  their  approval  of  the 
suggested  changes. 

If  this  spirit  prevails  throughout  the  audit  the  client  will 
be  benefited,  the  office  staff  will  be  enthusiastic  over  the 
innovation,  and  the  auditor  will  receive  a  unanimous  invita- 
tion to  come  again. 

4.  Compensation  Must  Depend  on  Service  Rendered 

The  professional  accountant  offers  his  services  to  the 
business  public  as  an  adviser  as  well  as  an  analyst  or  auditor ; 
therefore  it  is  obvious  that  the  matter  of  compensation  and 
status  cannot  be  determined  as  it  can  in  those  occupations 
where  the  matter  of  output  or  results  can  be  measured.  You 
cannot  gauge  an  output  of  brains  as  you  can  a  stated  amount 
of  manual  labor. 

Great  harm  has  been  done  to  the  profession  by  certain 
advertisers  who,  for  the  purpose  of  selling  correspondence 
courses  in  accountancy,  have  exaggerated  the  compensation 


34  AUDITING 

of  professional  accountants.  There  is  no  reason  why  the 
profession  should  be  better  paid  than  any  other  which  serves 
the  public  to  an  equal  degree.  The  implication  in  these 
advertisements  that  there  is  some  fixed  scale  of  fees  which 
an  accountant  can  charge  is  more  or  less  correct,  and  it  is 
unfortunate  that  such  is  the  case,  for  it  tends  to  place  the 
profession  on  a  par  with  day  laborers. 

If  all  accountants  are  to  charge  alike  for  their  services, 
where  is  the  incentive  to  excel  and  what  kind  of  profession 
would  it  be  if  there  were  no  premium  on  ability  and  ex- 
perience ?  The  best  lawyers  and  the  best  doctors  sometimes 
charge  lower  fees  for  the  same  service  than  less  experienced 
and  less  competent  practitioners,  but  such  reduction  is  none 
the  less  professional. 

So  with  accountants,  as  time  goes  on  there  will  be  less 
and  less  uniformity  in  charges,  and  the  more  skilful,  capable, 
experienced  accountant  will  not  consider  it  necessary  to 
place  a  fixed  per  diem  rate  on  his  services.  Nevertheless, 
under  present  conditions  per  diem  rates  yield  the  greatest 
compensation.  Where  flat  fees  are  charged  it  almost  always 
means  that  some  concession  has  been  or  will  be  made  in  the 
per  diem  rate,  so  that  the  auditor  who  can  always  command 
liberal  day  rates  will  reap  the  greatest  financial  reward. 

The  one  good  argument  for  a  stated  fee  (and  it  is  a 
strong  one)  is  that  the  client  prefers  it  in  perhaps  nine  cases 
out  of  ten.  Professional  men  should  place  the  adherence  to 
the  ethics  of  their  profession  and  the  satisfaction  of  their 
clients  above  pecuniary  gain.  Therefore,  if  the  work  is 
fully  and  properly  performed  and  the  client  is  satisfied,  the 
method  or  rate  of  compensation  should  be  secondary,  and 
a  round  fee,  under  such  circumstances,  is  quite  as  ethical 
as  a  per  diem  rate. 

If  the  fee  has  not  been  arranged  beforehand  and  litiga 
tion  is  necessary,  the  auditor  will  receive  the  usual  profe 


I 


HOW   .TO    BEGIN    AN    AUDIT  35 

sional  fee,  provided,  of  course,  that  witnesses  can  be  obtained 
to  testify  that  the  work  measures  up  to  the  usual  standard 
of  professional  work  and  that  the  fee  is  a  reasonable  one. 

Juries,  however,  are  apt  to  be  more  unreasonable  than 
clients  with  respect  to  professional  charges,  and  the  rule  of 
arranging  fees  beforehand  should  not  be  deviated  from 
except  in  special  cases. 

Several  years  ago  an  inquiry  into  the  actual  rates 
charged  by  accountants  was  conducted  in  New  York  City. 
There  was,  of  course,  a  wide  divergence  between  the  fees 
named  by  well-established  firms  having  a  large  clientele  and 
the  accountant  just  starting  in  practice.  The  result  of  the 
inquiry  is  mentioned  here  for  what  it  is  worth,  and  without 
any  attempt  to  set  it  up  as  a  standard  for  other  parts  of  the 
country,  nor  even  for  accountants  practicing  in  New  York 
City. 

The  questions  and  ajiswers,  with  slight  modifications  in 
the  form,  were  as  follows : 

Q.  What  is  the  maximum  rate  received  per  day,  and  for  what 
class  of  work? 

A.  $100  per  diem  was  the  maximum  rate  received,  and  that  only 
for  a  special  class  of  work,  such  as  an  investigation  calling  for  particu- 
larly expert  knowledge.  In  one  case,  however,  $250  per  day  was 
charged  for  a  few  days'  service. 

Q.     What  is  the  minimum  rate  per  day  received? 

A.    $10  per  day. 

Q.  What  is  a  fair  average  rate  for  accountants  of  the  highest 
class  ? 

i\.    $50  per  day. 

Q.  What  is  a  fair  average  rate  for  accountants  who  might  be 
considered  as  not  of  the  highest  class? 

A.    $25  per  day. 

Q.  What,  in  your  opinion,  would  be  a  standard  rate  for  investiga- 
tions requiring  first-class  ability,  as  a  minimum? 

A.    $25  per  day. 

Q.  What,  in  your  opinion,  should  be  the  rate  for  ordinary  audits 
and  examinations  not  requiring  the  highest  ability,  as  a  minimum? 

A.    $15  per  day. 


36 


AUDITING 


Q.  If  you  were  establishing  standard  rates,  taking  all  circum- 
stances fairly  into  consideration,  what  rates  would  you  advise? 

A.  For  standard  rates  the  minimum  fee  for  the  man  in  charge 
should  be  $25  per  day;  for  ordinary  assistants,  $15;  and  for  juniors 
used  in  clerical  checking,  $10  per  day ;  but  the  restriction  of  this  com- 
pensation is  not  advocated,  especially  for  those  in  charge  of  work,  to 
$25  per  day. 

Q.     To  what  extent  are  assistants  used  ? 

A.  Probably  90  per  cent  of  accountants  in  active  practice  use 
assistants. 

Q.  What  are  the  maximum  and  minimum  per  diem  rates  received 
for  the  services  of 

(a)  Senior  assistants? 

(b)  Junior  assistants? 

A.  Senior:  maximum,  $25;  minimum,  $15.  Junior:  maximum,  $15; 
minimum,  $10. 

Contingent   Fees 

One  of  the  proposed  amendments  to  the  by-laws  of  the 
American  Association  of  Public  Accountants  provided  that : 
"No  member  shall  agree  to  perform  accountancy  work  pay- 
ment for  which  is  contingent  upon  the  result  of  litigated  or 
arbitrated  issues." 

It  is  proper  that  the  auditor  should  avoid  even  the  ap- 
pearance of  evil,  but  it  is  a  debatable  question  as  to  w^hether 
this  rule  is  not  so  strict  that  literal  compliance  therewith  is 
impracticable.  If  this  is  the  case,  the  rule  should  be  re- 
framed  in  order  to  express  properly  the  thought  that  it  is 
always  wrong  for  an  auditor  to  undertake  work  which  he 
cannot  conscientiously  certify  to,  or  to  submit  figures  which 
may  reflect  his  prejudices  rather  than  his  honest  convictions. 

As  a  matter  of  fact,  auditing  work  may  be  performed 
upon  the  basis  of  a  contingent  fee,  the  propriety  or  honesty 
of  which  can  no  more  be  questioned  than  if  it  were  under- 
taken upon  a  basis  of  per  diem  rates. 

An  actual  experience  will  illustrate  the  point.  A  cashier 
w^ho  had  access  to  the  books  of  a  corporation  forged  the 
indorsements  on  certain  customers'  cheques  and  misappro- 


HOW    TO    BEGIN    AN    AUDIT  37 

priated  the  proceeds.  The  president  discovered  the  fraud 
and  attempted  to  locate  the  items  in  order  to  recover  from 
the  banks  which  cashed  the  cheques,  but  he  was  unfamiliar 
with  bookkeeping  methods  and  was  only  partially  successful. 
He  suggested  to  a  professional  auditor  that  the  books  be 
carefully  audited  and  that  the  full  amount  for  which  the 
banks  could  be  held  responsible  be  ascertained.  He  had  an 
unreasonable  fear  that  the  work  might  be  very  expensive 
and  the  results  unfruitful,  so  he  suggested  to  the  auditor 
that  the  latter  should  receive  one-half  of  the  net  amount 
recovered  in  full  payment  for  his  services.  The  auditor 
accepted  the  proposition,  unearthed  claims  aggregating 
several  thousand  dollars,  and  received  for  his  services  some- 
thing in  excess  of  his  regular  per  diem  rates. 

The  banks  did  not  pay  willingly  and  required  the  most 
complete  proof  before  making  settlement.  The  auditor 
could  not  in  any  possible  way  have  improperly  influenced 
the  results,  so  that  if  he  had  refused  the  engagement  be- 
cause his  compensation  depended  upon  a  contingency,  he 
would  have  suffered  an  unnecessary  pecuniary  loss  and  his 
client  might  have  lost  an  equal  amount. 

In  the  opinion  of  the  author,  the  auditor  should  subject 
each  engagement  to  scrutiny  to  discover  any  possible  reasons 
why  he  should  not  undertake  it.  Work  which  involves  his 
integrity  should  always  be  declined.  But  if  he  can  con- 
scientiously accept  work  w  here  his  fee  depends  upon  a  con- 
tingency, he  should  not  refuse  the  required  service. 

5.  As  to  Where  the  Work  Is  Done 

This  question  receives  but  little  consideration  in  the 
usual  audit  until  it  is  too  late  to  make  a  change.  Most  audits 
are  made  in  the  office  where  the  general  books  of  account 
are  written  up.  Provided  there  are  ample  space,  adequate 
light,  satisfactory  and  sanitary  working  conditions  such  as 


38 


AUDITING 


pure  air,  etc.,  and  reasonable  freedom  from  interruption  by 
unauthorized  persons,  this  is  the  ideal  place. 

When  the  audit  is  being  arranged  for,  all  of  these  points 
can  be  discussed,  and  few  clients  will  hesitate  to  modify  or 
improve  existing  conditions  in  order  that  the  audit  work 
may  be  performed  under  favorable  auspices.  But  if  this 
matter  is  left  in  abeyance  until  the  audit  is  actually  com- 
menced, changes  are  almost  impossible  to  effect,  or  if  not 
impossible,  the  auditor  usually  deems  it  inadvisable  to  open 
up  the  subject. 

Therefore,  stipulate  for  the  best  possible  working  condi- 
tions before  zvork  is  commenced. 

6.  Working  Papers 

It  may  sound  paradoxical,  but  the  time  to  arrange  work- 
ing papers  is  before  the  actual  work  of  the  audit  begins. 

The  most  important  point  to  emphasize  is  that  the  more 
inexperienced  an  auditor  is,  the  more  working  papers  he 
produces,  so  that  the  student  or  practitioner  who  aspires  to  a 
high  place  in  his  profession  will  avoid  all  unnecessary  com- 
pilations and  comments;  he  will  try  to  settle  his  doubts 
relative  to  questionable  transactions  immediately,  for  the 
majority  of  his  questions  will  be  answered  satisfactorily; 
he  will  eliminate  the  copying  of  trial  balances,  statements, 
etc.,  unless  he  has  a  clear  idea  as  to  their  ultimate  use,  and 
he  will  ruthlessly  destroy  his  papers  as  soon  as  their  value 
is  questionable. 

It  is  a  pity  that  the  limits  of  this  book  make  it  imprac- 
ticable to  include  detailed  illustrations  of  how  things  should 
be  done  and  how  they  should  not  be  done.  Perhaps  the 
assertion  that  the  skill  of  an  accountant  can  always  be 
ascertained  by  an  inspection  of  his  working  papers  is  too 
sweeping,  but  it  will  hold  good  in  so  many  cases  that  it  may 
as  well  be  called  a  general  rule,  and  therefore  prospective 


HOW    TO    BEGIN    AN    AUDIT  39 

auditors  should  take  notice  that  some  day  they  may  be 
so  judged. 

If  the  professional  man  were  as  careful  with  his  tools 
as  is  the  mechanic,  he  would  do  better  work  and  he  would 
save  himself  many  hours  of  duplicated  labor.  The  average 
lawyer,  for  instance,  makes  his  notes  on  scraps  of  paper 
and  in  such  an  unsystematic  way  that  an  orderly  filing  of 
them  is  impossible.  Subsequently  (in  many  cases)  the  notes 
cannot  be  found,  or  if  found,  they  cannot  be  understood. 
Fortunately  for  the  lawyer,  his  notes  are,  in  a  majority  of 
cases,  not  required  later,  which  accounts  perhaps  for  his 
carelessness. 

But  an  accountant  must  be  the  personification  of  order 
and  system;  his  business  is  to  criticize  careless  methods  in 
others  and  construct  proper  systems  for  those  who  have 
none.  Therefore  he  must  convey  the  impression  that  he 
appreciates  order  and  good  methods  and  be  able  to  demon- 
strate this  by  an  exhibition  of  the  highest  degree  of  perfec- 
tion in  his  own  working  papers. 

Stationery  is  cheap,  far  cheaper  in  proportion  than  the 
implements  used  by  mechanics,  yet  many  accountants  will 
use  a  scrap  of  paper  or  the  back  of  an  envelope  to  make  a 
record  in  connection  with  an  audit,  when  the  items  so  noted 
are  important  enough  to  be  set  down  in  an  orderly  way  on  a 
whole  sheet  of  specially  ruled  paper.  It  really  seems  absurd 
to  devote  much  space  to  this  matter,  and  it  is  only  because 
there  is  such  a  widely  prevalent  looseness  in  this  respect  that 
emphasis  is  given  to  the  use  of  good  stationery  and  im- 
portance placed  on  plenty  of  stationery  always  being 
available. 

An  accountant  or  a  bookkeeper  should  have  on  hand  at 
all  times  a  complete  assortment  of  specially  ruled  paper  of 
all  sizes.  Let  him  consider  this  as  part  of  his  plant,  if 
need  be,  for  a  very  small  expenditure  will  secure  a  large 


40 


AUDITING 


supply  of  paper.     The  special  rulings  should  cover  every 
form  for  which  there  may  be  the  slightest  call. 

With  respect  to  money  columns,  paper  should  be  ruled 
having  from  three  to  eighteen  columns.  The  former  will 
be  the  most  used,  but  there  is  a  constant  call  for  the  latter. 
Then,  of  course,  ledger-ruled  paper  will  frequently  be  used, 
and  it  is  very  desirable  to  have  ledger  paper  with  two  money 
columns  on  both  sides.  The  paper  should  be  put  up  in  pads 
of  fifty  sheets  each. 

In  commencing  an  audit,  a  full  assortment  of  paper, 
together  with  various  colored  pencils  or  ink,  etc.,  will  be 
gathered  together  and  carried  preferably  in  a  stout  leather 
portfolio  with  a  first-class  lock  on  it  and  containing  con- 
venient pockets  for  papers,  pencils,  rubber  stamps,  etc.  Is 
it  not  obvious  that  a  client  or  a  client's  clerk  will  have  more 
respect  for  an  auditor  who  is  fully  equipped  than  for  a  man 
who  is  compelled  to  borrow  first  a  sheet  of  paper  and  next  a 
pencil  in  order  to  record  details  of  the  petty  cash  as  counted  ? 
First  impressions  are  lasting. 

It  is  no  excuse  to  urge  that  many  offices  of  comparatively 
wealthy  concerns  are  woefully  lacking  in  good  stationery 
and  that  a  little  pile  of  carefully  cut  used  envelopes  for 
making  memoranda  is  still  in  evidence  in  many  offices.  In 
most  cases  such  a  supply  is  sufficient  for  the  bookkeeper 
who  is  not  in  possession  of  ruled  paper,  and  who  probably 
does  not  see  any  necessity  for  having  it  on  hand.  He  is  so 
blissfully  unconscious  that  there  are  scores  of  uses  to  which 
he  might  put  some  well-ruled  paper  for  the  edification  an< 
financial  benefit  of  his  employer,  and  which  would  almost 
surely  result  in  an  increase  in  his  own  salary,  that  it  is  no< 
fair  to  the  wide-awake  man  to  say  too  much  about  it.  Th< 
benighted  user  of  old  scrap  paper  will  simply  make  wa^ 
some  day  for  a  more  competent  successor. 

The  professional  auditor,   however,   cannot   afford   t< 


HOW    TO    BEGIN    AN    AUDIT  41 

start  wrong,  for  he  does  not  have  the  same  opportunity  for 
concealing  his  incompetency.  Stock  up,  therefore,  and  keep 
stocked  up,  for  a  few  extra  dollars  invested  in  a  big  supply 
of  stationery  will  be  the  greatest  possible  help  to  the  young 
practitioner.  Having  the  paper,  use  it.  That  is,  don't  even 
try  to  economize,  for  it  is  not  safe  to  temporize  and  think 
that  a  particular  memorandum  is  unimportant  and,  there- 
fore, just  as  well  recorded  on  a  scrap  as  on  a  whole  sheet 
which  may  have  cost  a  quarter  of  a  cent. 

It  will  be  a  great  convenience  to  head  up  separate  sheets 
of  paper  at  the  commencement  of  an  audit  along  the  follow- 
ing lines :  ''Cash  Vouchers  Lacking'' ;  "Errors  in  Footings — 
Cash  Book'';  ''Errors  in  Footings — Sales  Book";  "Errors 
in  Postings  —  Private  Ledger";  "Suggestions  and 
Comments" ;  "Defects  in  System" ;  "Missing  Internal 
Checks." 

There  should  be  an  absolute  rule  strictly  adhered  to, 
forbidding  the  writing  of  more  than  one  class  of  errors  on 
the  same  sheet  of  paper.  If,  for  instance,  an  audit  develops 
but  three  errors  in  footings  and  postings,  one  being  in  the 
cash  book,  one  in  the  journal,  and  one  in  the  sales  ledger, 
there  should  be  three  sheets  of  paper  submitted  at  the  close 
of  the  work,  one  error  appearing  on  each.  The  reason  for 
this  is  evident.  The  work  covered  is  assumed  to  be  a  test 
only,  and  no  one  can  tell  how  many  errors  may  develop  if 
additional  verification  is  required. 

It  is  almost  criminal  for  an  accountant  to  write  and  re- 
write and  classify  and  reclassify  his  memoranda  during  the 
course  of  an  audit,  when  every  bit  of  the  rewriting  and 
reclassification  could  have  been  avoided  by  using  one  sheet 
of  paper  for  each  class  of  errors  or  queries. 

There  is  a  general  habit  to  minimize  the  importance  of 
working  papers,  and  while  the  client  suffers  most  because 
his  affairs  are  not  properly  looked  after,  yet  the  auditor  who 


42 


AUDITING 


starts  in  wrong  does  himself  positive  harm  by  not  getting 
the  most  out  of  each  engagement. 

An  auditor  who  is  careless  about  his  working  papers  has 
taken  up  an  audit,  and  having  forgotten  to  supply  himself 
with  stationery,  calls  on  the  client's  supply.  Irregular  pieces 
of  scrap  paper  are  supplied  to  him,  and  on  these  he  makes 
his  various  notes  and  comments.  He  dislikes  to  ask  too 
often  for  paper,  and  so  economizes  by  using  both  sides  of 
some  pieces  and  fills  others  to  the  limit.  By  the  time  the 
audit  is  completed  he  has  a  veritable  mess  of  scraps.  He 
then  vainly  attempts  to  make  sense  out  of  a  lot  of  notes 
which  were  considered  of  great  importance  when  made  and 
which  would  have  been  written  out  properly  if  the  means 
had  been  at  hand.  How  is  it  possible  for  such  a  man  to 
.write  a  report  of  the  greatest  possible  value  to  his  client? 
Even  if  he  finally  deciphers  all  of  his  notes  and  does  not 
forget  to  look  on  the  back  of  every  scrap,  he  has  made  so 
much  trouble  for  himself  that  in  consequence  thereof  he  has 
written  a  report  in  a  troubled  and  irritated  frame  of  mind 
and  his  careless  style  has,  of  course,  permeated  the  text. 

Consider  the  case  of  an  auditor  who  takes  the  trouble  to 
provide  himself  with  an  ample  supply  of  paper;  who  uses  a 
separate  sheet  for  each  class  of  error,  suggestion,  or  com- 
ment. When  he  is  ready  to  write  the  report  he  merely  sorts 
his  working  papers,  and  with  full  notes  before  him,  with  no 
irrelevant  matters  constantly  interrupting  his  train  of 
thought,  has  simply  to  proceed  in  an  orderly  manner  to 
the  close. 

Is  it  worth  while?  Who  has  the  better  chance  for 
another  engagement  from  the  client  so  served  ? 

Permanent  Filing 

After  a  report  has  been  written  great  care  must  be 
taken  to  file  working  papers  intelligently  and  according  to  a 


HOW    TO    BEGIN    AN     AUDIT  43 

well-laid-out  and  thoroughly  understood  plan,  or  serious 
inconvenience  may  be  sustained  on  subsequent  occasions 
when  a  particular  schedule  or  reconciliation  sheet  is  required 
in  a  hurry. 

A  plan  which  has  been  followed  with  success  is  the 
following : 

Commencing  with  the  balance  sheet  submitted  to  the 
client  each  item  thereon  is  assigned  a  letter.  For 
instance,  if  plant  is  the  first  item  among  the  assets,  the 
letter  A  is  assigned  thereto.  Each  schedule  relating  to 
plant  would  be  marked  Al,  A2,  A3,  etc.,  and  all  papers 
containing  information  bearing  thereon  are  grouped 
accordingly. 

The  same  plan  applies  to  the  profit  and  loss  statement, 
and  to  any  other  schedules  where  the  supporting  papers  are 
numerous. 

When  the  single  letters  are  exhausted,  double  letters  may 
be  used  as  AA,  BB,  etc.  Variations  of  this  plan  will  suggest 
themselves  to  the  auditor  who  has  had  difficulty  in  locating 
working  papers. 

7.  Familiarity  with  System  in  Use 

During  the  auditor's  early  training  he  will  have  had  an 
opportunity  to  acquire  special  knowledge  with  respect  to 
many  lines  of  commercial  activity,  so  that  many  of  his 
engagements  will  cover  undertakings  the  special  features  of 
which  will  be  familiar  to  him.  It  is  impossible,  however, 
for  any  auditor  to  have  experience  in  every  line  of  busi- 
ness, and  engagements  will  have  to  be  made  to  audit  accounts 
of  which  he  has  no  technical  or  special  knowledge.  He  is 
not  expected  to  have  the  special  knowledge,  but  he  should 
explain  that  the  fundamentals  of  all  businesses  are  similar 
and  that  he  is  thoroughly  versed  therein. 

An  admission  as  to  his  unfamiliarity  will  win  greater 


44 


AUDITING 


respect  than  an  attempt  to  conceal  his  ignorance;  progress 
cannot  be  made  without  asking  many  questions,  and  it  will 
not  take  a  client  long  to  discover  the  ignorance  if  an  attempt 
is  made  to  conceal  it.  In  any  event,  and  despite  long  ex- 
perience with  the  same  class  of  business,  the  auditor  should 
ask  questions  about  the  personnel  and  the  special  features  of 
the  business  under  review. 

Local  conditions  and  peculiarities  may  sometimes  pro- 
duce strange  results,  and  the  auditor  will  find  it  easy  to 
acquire  a  broad  knowledge  of  many  things  during  his  pre- 
liminary conferences  which  would  later  take  far  more  time 
to  acquire.  The  client  and  his  staff  expect  to  be  asked  a  lot 
of  questions  (intelligent  and  tactful  ones,  of  course)  at  first, 
and  the  wise  auditor  will  make  copious  notes  of  the  informa- 
tion so  derived.  The  client  will  probably  volunteer  the  his- 
tory of  his  life  and  the  progress  of  his  business  in  great 
detail,  and  advantage  should  be  taken  of  such  an  opportunity 
to  grasp  the  technical  points  of  the  business.  Later  on 
it  may  be  difficult  to  catch  the  client  in  the  same  frame  of 
mind. 

The  auditor  may  be  asked  whether  he  can  make  a  satis- 
factory audit  of  single-entry  books.  Of  course  there  is  no 
difference  at  all  so  far  as  auditing  principles  are  concerned. 

In  single-entry,  as  in  double-entry  systems,  the  auditor 
will  see  that  all  assets  which  should  be  on  hand  are  properly 
accounted  for;  that  all  income  which  should  have  been 
recorded  has  been  found  to  be  in  order ;  and  will  apply  all 
the  general  principles  of  auditing.  Single-entry  books  doj 
not  readily  lend  themselves  to  tests  and  automatic  checks 
as  do  double-entry  records,  but  there  are  no  fundamental 
differences.  More  details  will  have  to  be  verified,  and  there! 
will  be  difficulties  in  the  way  of  preparing  satisfactory  bal- 
ance sheets  and  profit  and  loss  statements.  But  these  are  not] 
matters  which  require  special  treatment  in  this  book. 


HOW    TO     BEGIN    AN    AUDIT 


45 


8.  Schedules  of  Books,  Records,  and  Names  of  Clerks 

A  mastery  of  the  general  system  in  use  includes  a  com- 
prehensive knowledge  of  the  books  and  records  which  con- 
tain the  transactions  of  the  business  under  audit.  Books  of 
account  are  the  histories  of  business  enterprises.  As  a 
history  is  not  complete  unless  it  records  an  unbroken  narra- 
tive of  facts,  the  auditor  must  determine  whether  or  not  he 
will  find  such  a  continuous  record  of  the  transactions  of  the 
business  in  the  books  submitted  to  him. 

The  time  to  determine  this  is  before  the  audit  begins,  and 
at  the  time  of  the  inquiry  a  full  description  of  the  records 
should  l:>e  made  and  the  names  of  the  clerks  responsible 
therefor  carefully  noted.  These  names  will  be  needed  subse- 
quently and  when  reporting.  It  arouses  suspicion  to  ask 
for  names  when  needed. 

In  England,  it  is  customary  in  most  cases,  and  compul- 
sory in  others,  for  the  auditor  to  be  supplied  with  a  list  of 
the  books  in  use.  In  this  country  the  advantage  of  this 
precaution  is  strangely  neglected. 

No  book  should  be  listed  until  its  use,  or  abuse,  is  fully 
comprehended.  This  is  a  favorable  opportunity  to  fill  out 
any  gaps  in  the  complete  survey  of  the  business  which  the 
auditor  must  possess. 

The  answers  to  the  preliminary  questions  and  a  detailed 
schedule  of  all  the  books  in  use  should  form  the  basis  for 
an  intelligent  study  of  how  to  begin. 

9.  Procedure  where  Previous  Audits  Have  Been  Made 

A  prominent  accountant  estimates  that  not  more  than  10 
per  cent  of  the  business  concerns  of  this  country  have  their 
accounts  audited.  But  as  most  of  the  work  that  is  done  is 
satisfactory,  it  is  only  in  rare  cases  that  one  auditor  replaces 
another. 

It  is  not  considered  ethical  for  one  auditor  to  supplant 


46  AUDITING 

another  where  the  only  reason  for  the  change  is  that  of 
remuneration.  If  a  client  expresses  dissatisfaction  with  the 
work  of  one  auditor  and  announces  his  intention  of  retain- 
ing another,  there  can  be  no  objection  to  the  appointment. 

Wherever  feasible,  the  auditor  should  receive  a  copy 
of  his  predecessor's  report,  but  if  it  cannot  be  had,  his  in- 
spection of  the  books,  and  the  unsolicited  remarks  of  the 
client's  staff,  will  probably  indicate  the  extent  of  the  previous 
audit. 

Of  course,  no  auditor  could  be  held  responsible  for  the 
acts  or  omissions  of  another  auditor,  but  he  would  have  no 
justification  for  blindly  following  the  procedure  of  a  previ- 
ous audit,  even  though  tVie  client  requested  it.  Therefore 
the  auditor  should  regard  all  that  he  learns  of  his  prede- 
cessor's work  as  information  purely  supplemental  to  that 
already  pointed  out  as  important,  and  weighing  all  together, 
he  will  proceed  as  his  own  best  judgment  dictates. 

Sometimes,  from  a  feeling  of  delicacy,  the  auditor  will 
not  insist  on  a  full  explanation  as  to  why  the  previous 
auditor's  services  have  been  dispensed  with.  In  view,  how- 
evef,  of  the  fact  that  auditors  have  been  displaced  for  failure 
to  discover  specific  weak  spots,  it  is  obvious  that  the  succeed- 
ing auditor  would  be  at  a  disadvantage  without  this  knowl- 
edge, so  that  in  all  cases  insistence  on  an  explanation  can  do 
no  harm  and  may  be  very  useful. 

Shortly  stated,  a  safe  general  rule  is  to  proceed  as  if  no 
previous  audit  had  been  made,  unless  complete  reports  of 
another  auditor,  in  whom  the  fullest  confidence  is  placed, 
are  in  evidence,  and  unless  there  is  no  question  as  to  the 
reason  for  the  former  auditor's  di-splacement. 

10.  Final  Considerations:  Detailed  or  Balance  Sheet  Audit? 

It  might  be  inferred  that  having  studied  the  matter  from 
so  many  standpoints,  and  particularly  after  having  had  a 


HOW    TO    BEGIN    AN    AUDIT 


47 


final  interview  with  the  client,  there  would  remain  nothing 
to  do  but  to  commence  the  actual  work. 

This,  however,  is  not  the  case.  Now  is  the  most  im- 
portant time  for  calm  reflection.  Up  to  this  point  many 
features  were  more  or  less  uncertain.  The  client's  under- 
standing of  the  state  of  his  books  and  the  detail  therein  and 
the  explanations  of  the  clerks,  together  with  a  survey  of  the 
books  themselves,  all  affect  the  final  decision  as  to  what 
should  be  done. 

Frequently  a  client  will  make  the  broad  assertion  that 
he  wants  a  complete  and  detailed  examination  of  his  books. 
Subsequent  inquiry  may  develop  the  fact  that  a  first-class 
system  of  internal  check  exists,  or  that  the  transactions  are 
so  numerous  that  a  detailed  examination  is  quite  out  of  the 
question.  Therefore  the  auditor  should  reserve  final  de- 
cision as  to  the  scope  of  his  work  until  he  has  inspected  the 
books  and  interviewed  those  in  charge  thereof. 

The  final  point  to  be  decided  is:  Shall  a  detailed  or  a 
balance  sheet  audit  be  made?  These  two  classes  of  audits 
are  discussed  fully  in  subsequent  chapters,  but  it  is  desirable 
that  a  brief  survey  of  each  be  made  at  this  point  in  order 
that  we  may  now  completely  cover  every  phase  of  prepara- 
tion up  to  the  actual  physical  work  of  the  audit  itself. 

In  dividing  audits  into  two  classes,  the  author  has  not 
failed  to  consider  another  class,  viz.,  "cash"  audits.  The 
title  1*3  a  misnomer^  »however,  because  many  attempts  to  limit 
an  auditor  to  an  examination  of  cash  records  have  either 
resulted  in  an  incomplete  and  unsatisfactory  task,  or  else 
the  work  has  naturally  extended  into  other  records  comple- 
mentary to  the  cash  account,  which,  of  course,  are  vitally 
necessary  to  a  proper  audit. 

A  professional  auditor  probably  should  not  refuse  point 

blank  to  make  a  so-called  cash  audit  when  requested  to  do 

^  so,  but  he  should  explain  fully  and  carefully  that  most  fraud 


48  AUDITING 

and  carelessness  lie  in  the  transactions  which  do  not  reach 
the  books;  that  the  cash  account  in  itself  is  only  a  portion 
of  a  system,  every  part  of  which  depends  upon  and  works 
into  the  others.  He  should  explain  that  to  accept  a  cash  book 
as  correct  is  unwise,  because  it  is  not  what  is  in  the  book 
and  accounted  for  that  is  of  interest,  but  rather  what  is  not 
there,  evidence  of  or  clues  to  which  might  be  found  in  the 
other  books  and  records. 

Perhaps  the  safest  answer  for  the  auditor  to  give  would 
be  the  statement  that  there  is  no  such  thing  as  a  cash  audit, 
and  follow  that  statement  by  an  explanation  of  the  points 
usually  covered  in  a  detailed  audit  and  in  a  balance  sheet 
audit. 

The  Detailed  Audit 

In  all  cases  where  a  complete  examination  is  desired 
or  desirable  a  detailed  audit  should  be  made.  In  those 
undertakings  where  there  is  no  satisfactory  internal  check, 
the  detailed  audit  is  the  only  one  which  will  cover  the  income 
and  expenditures  for  the  period  under  audit.  This  applies, 
therefore,  chiefly  to  small  enterprises,  but  as  the  organiza- 
tions which  have  a  complete  system  of  internal  check  are 
very  much  in  the  minority,  the  auditor  will  most  frequently 
have  to  undertake  a  detailed  audit.  But  a  detailed  audit  in 
the  sense  in  which  it  is  used  here  does  not  contemplate  the 
verification  of  every  item  in  the  books. 

Not  many  years  ago  one  of  the  principal  features  of 
every  audit  was  the  inspection  and  verification  of  vouchers 
for  cash  payments.  In  many  instances  certificates  stated 
without  reserve  that  the  ''accounts  have  been  audited  and 
found  to  be  correct,"  when,  as  a  matter  of  fact,  absolutely 
nothing  else  was  done  but  to  compare  certain  receipts  pur- 
porting to  represent  payments  of  cash  and  acknowledg- 
ments thereof,  with  the  payment  side  of  the  cash  book.    The 


HOW    TO    BEGIN    AN    AUDIT 


49 


certificates  appearing  at  the  end  of  treasurers'  statements 
in  most  published  reports  of  charitable  and  religious  institu- 
tions show  just  such  a  state  of  afifairs. 

It  seemed  conclusive  to  many  people  that  if  a  cashier  or 
a  treasurer  could  furnish  a  voucher  for  every  item  of  cash 
disbursement,  there  simply  could  not  be  anything  wrong 
about  the  accounts  as  a  v/hole.  As  the  science  of  accounts 
developed,  some  auditors  were  not  satisfied  with  this,  and 
they  supplemented  the  examination  of  the  vouchers  by  a 
complete  verification  of  the  footings  and  postings.  Having 
done  this,  they  were  content,  and  felt  that  great  strides  had 
been  made  in  the  art.  Add  to  the  above  the  checking  of  the 
trial  balance  and  you  will  have  the  full  program  of  a  large 
percentage  of  audits — certainly  up  to  ten  or  fifteen  years 
ago.  Sad  to  relate,  a  considerable  number  of  present-day 
audits  vary  little  from  this  procedure,  in  spite  of  the  fact 
that  professional  auditors  now  have  an  opportunity  to  profit 
by  the  mistakes  of  their  predecessors  and  to  use  more 
scientific  methods  in  their  work.  Some  auditors,  however, 
do  all  their  thinking  after  they  start  to  work,  and  will  not 
take  the  time  and  trouble  to  plan  ahead. 

Careful  consideration  of  a  large  number  of  defalcations 
reveals  the  fact  that  most  of  them  would  not  have  been  dis- 
covered by  a  verification  of  the  vouchers,  footings,  postings, 
or  trial  balances.  This  fact  does  not  eliminate  the  necessity 
for  proper  attention  to  such  work,  but  it  does  emphasize 
the  greater  necessity  for  attention  to  the  work  which 
experience  shows  is  productive  of  the  most  satisfactory 
results. 

An  a,uditor  must  at  all  times  study  and  think  and  appre- 
ciate the  need  of  preparing  all  his  plans  on  a  relative  scale. 
Conceding  the  obvious  conclusion  that  no  audit  can  or  should 
embrace  a  complete  verification  of  all  the  transactions  of  the 
period  under  review,  then  the  process  of  elimination  must 


so 


AUDITING 


proceed  scientifically  and  with  the  definite  goal  in  view  that 
the  points  covered  will  coincide  with  the  weak  spots. 

In  the  succeeding  chapters  the  author  will  outline  the 
procedure  for  a  detailed  audit  in  which  proper  weight  is 
given  to  the  verification  of  the  routine  bookkeeping,  but 
laying  more  stress  on  other  phases  of  the  accounts  which 
have  proven  to  be  those  most  susceptible  to  fraud,  careless- 
ness, and  ignorance. 

Where  there  is  a  satisfactory  system  of  internal  check, 
the  auditor  is  not  expected,  and  should  not  attempt,  to  make 
a  detailed  audit.  The  word  ''satisfactory,"  however,  is  used 
advisedly,  for  more  than  one  large  corporation  with  a 
comptroller  and  a  force  of  staff  auditors  lacks  a  complete 
system  of  internal  check. 

When  the  staff  auditor  is  also  an  official  in  the  business, 
he  is  seriously  handicapped  when  he  endeavors  to  check  the 
records  of  other  departments  of  the  organization.  There 
are  so  many  opportunities  to  impose  administrative  func- 
tions upon  him  that  within  a  short  time  his  supervisory  and 
auditing  duties  are  hopelessly  entangled.  Proof  of  the  fre- 
quent existence  of  this  condition  of  affairs  is  seen  in  the 
discovery  of  defalcations  on  the  part  of  officials  who  were 
not  supposed  to  have  access  to  funds  or  securities. 

If  the  staff  auditor  is  a  clerk,  his  position  is  still  more 
difficult  to  maintain.  If  his  superiors  are  dishonest,  he  soon 
has  to  choose  between  dismissal  or  silence.  Therefore  the 
mere  statement  that  an  auditing  department  exists  is  not 
enough  evidence  in  itself  to  obviate  the  necessity  for  a 
detailed  audit. 

Balance  Sheet  Audit 

If  the  auditor  has  satisfied  himself  that  the  system  of 
internal  check  is  adequate,  he  will  not  attempt  to  duplicate 
work  which  has  been  properly  performed  by  some  one  else. 


HOW    TO     BEGIN    AN    AUDIT 


SI 


,  His  duty  will  then  be  to  verify  the  assets  and  liabilities, 
and  to  make  such  an  analysis  of  the  profit  and  loss 
account  as  will  enable  him  to  certify  that  it  has  been  properly 
stated. 

But  there  is  a  much  wider  field  for  balance  sheet  auditing 
than  this.  Bankers  are  awakening  to  the  value  of  certified 
statements  from  borrowers  or  prospective  borrowers,  and 
there  are  vast  possibilities  in  this  class  of  work.  The  auditor 
who  can  undertake  these  engagements  with  a  clear  outline 
of  what  is  to  be  covered,  and  more  important  still,  what  may 
be  omitted,  has  a  tremendous  advantage  over  the  auditor 
who  does  not  appreciate  the  peculiar  circumstances  which 
surround  this  class  of  work.  Balance  sheet  audits  are  also 
required  in  many,jithercases.  The  author  will,  in  another 
chapter,  attempt  to  set  forth  as  concisely  as  possible 
what,  in  his  opinion,  should  be  done  in  a  balance 
audit,  and  what  need  not  be  done,  and  what  should  not 
be  done. 

Suggestions  to  Clients*  Staff  before  Commencing  Work 

In  the  great  majority  of  audits  which  are  made  for  the 
first  time  the  client  will  have  informed  his  entire  staff  as  to 
his  intentions,  so  that  there  is  no  possible  chance  of  gaining 
any  advantage  by  surprising  them. 

Then,  too,  it  may  be  that  the  audit  is  being  made  at  the 
request  or  on  the  suggestion  of  one  or  more  of  the  staff. 
This  occurs  very  frequently  where  ambitious  bookkeepers 
and  cashiers  realize  that  the  methods  in  use  in  the  office  are 
obsolete. 

If  the  auditor  desires  full  co-operation,  he  should  seek 
an  opportunity  to  ascertain  the  condition  of  the  books  and 
records  as  soon  as  possible  after  the  engagement  has  been 
made.  He  will  gain  nothing  whatever  by  jumping  in  before 
the  books  kre  written  up  or  balanced. 

/ 


s^ 


AUDITING 


As  he  will  probably  be  asked  what  he  desires  in  the  way 
of  vouchers,  etc.,  the  following  memorandum  has  been  pre- 
pared. It  is,  of  course,  only  suggestive,  as  the  auditor  must 
be  governed  by  local  conditions  : 

1.  A  correct  trial  balance,  as  of  the  date  the  audit  is  to  be 
made,  should  be  prepared.  If  not  ready  by  the  time  the 
audit  is  to  be  commenced,  the  auditor  should  have  a  confer- 
ence with  the  client  and  the  bookkeeper  and  determine  (a)  if 
the  work  is  to  proceed  at  once;  (b)  if  it  is  to  be  postponed 
until  the  differences  are  located;  (c)  if  the  auditor,  acting 
as  an  accountant,  is  to  locate  the  errors. 

2.  Controlling  accounts  in  the  general  ledger  should  be 
in  agreement  with  the  subsidiary  records;  if  not  in  agree- 
ment, the  matter  should  be  discussed  with  the  client  and  an 
understanding  reached  as  to  whether  the  errors  are  to  be 
located  or  allowed  to  stand. 

3.  Schedules  of  notes  receivable  (whether  or  not  dis- 
counted), notes  payable,  bonds,  stocks,  etc.,  should  be 
prepared. 

4.  Monthly  statements  .from  creditors  should  be  pre- 
served. 

5.  Paid  bank  cheques  and  all  other  vouchers  should 
be  taken  from  the  files  and  arranged  as  requested  by 
the  auditor. 

The  auditor  should  not  disclose  the  use  he  proposes  to 
make  of  the  vouchers. 

6.  If  an  inventory  has  been  taken,  the  auditor  will  state 
to  what  extent  he  desires  the  certification  of  those  responsible 
therefor,  and  he  will  insist  on  the  original  sheets  being  pre- 
served and  submitted. 

7.  If  there  are  many  accounts  receivable,  it  may  be  wise 
to  request  that  they  be  divided  into  groups,  showing  all 
those  overdue,  etc.,  so  that  an  estimate  of  the  reserve  for 
bad  debts  may  readily  be  made. 


HOW    TO    BEGIN    AN    AUDIT  53 

SYSTEM  OF  INTERNAL  CHECK 

Reference  has  several  times  been  made  to  the  fact  that 
the  question  of  whether  a  detailed  audit  should  be  made, 
or  whether  a  balance  sheet  audit  will  accomplish  the  desired 
end  just  as  well,  depends  to  a  considerable  extent  upon  the 
existence  or  lack  of  a  satisfactory  system  of  internal  check. 

Such  a  system  consists  in  the  accounting  records, 
methods  and  details  generally  of  an  establishment  being  laid 
out  in  such  a  way  that  no  part  of  the  accounts  will  be  under 
the  absolute  and  independent  control  of  any  one  person; 
that,  on  the  contrary,  the  work  of  one  employee  will  be 
complementary  to  that  of  another;  and  that  a  continuous 
audit  will  be  made  of  the  details  of  the  business. 

While  the  details  of  a  system  of  internal  check  vary 
somewhat  in  different  cases,  the  following  general  points 
usually  require  careful  attention. 

Incoming  Mail 

Proper  provision  should  be  made  for  safeguarding  in- 
coming mail,  so  that  cash  received  shall  reach  the  cashier. 
The  opening  and  handling  of  incoming  mail  should  be  in 
charge  of  some  responsible  person,  preferably  an  officer  of 
the  company. 

All  remittances  should  be  listed  and  the  list  subsequently 
compared  with  the  cash  records. 

Cash 

All  cash  payments  should  be  made  by  cheque  signed  by 
one  of  the  principals  and  supported  by  a  duly  authorized 
voucher. 

All  money  received,  whether  in  the  form  of  cheques  or 
cash,  should  be  deposited  in  the  bank  daily. 

Small  payments  that  must  be  made  in  currency  should 
be  made  from  a  petty  cash  fund  set  aside  for  that  purpose. 


54 


AUDITING 


Receipts  or  vouchers  should  be  secured  for  all  disburse- 
ments from  this  petty  cash  fund,  and  at  frequent  intervals 
the  cashier  should  prepare  a  statement  of  disbursements 
made  from  the  petty  cash  fund.  Upon  surrender  of  this 
statement  accompanied  by  the  vouchers  or  receipts  and 
certified  to  by  him  as  to  the  correctness  of  the  items,  he 
should  be  reimbursed  by  cheque  for  the  total  amount  shown 
by  the  statement.  This  should  also  be  done  at  the  close  of 
every  fiscal  period". 

The  cashier  should  have  no  access  to  any  of  the  in- 
dividual ledgers,  nor  to  statements  sent  to  customers. 

The  bank  pass-books  should  be  balanced  or  a  statement 
of  account  secured  from  the  bank  at  least  monthly. 

The  outstanding  cheques  should  be  listed,  and  the 
balance  shown  to  be  in  bank  should  be  reconciled  with  the 
balance  called  for  by  the  cash  book. 

Invoices  for  Purchases 

The  issuing  of  orders  for  the  purchase  of  goods  or 
materials  is  one  of  the  most  important  duties  to  be  per- 
formed in  any  organization.  While  in  smaller  concerns  this 
work  is  frequently  performed  by  a  principal,  still  in  larger 
enterprises  it  is  usually  necessary  to  delegate  the  work  to 
an  employee. 

One  person  should  be  responsible  for  all  purchases. 
Requisitions  for  requirements  of  the  various  departments 
should  be  sent  to  him  and  formal  orders  issued  from  his 
department,  or  else  all  orders  issued  should  be  subject  to 
his  approval. 

As  a  general  rule  orders  should  state  prices  and  exact 
quantities  required. 

Duplicate  copies  of  all  orders  should  be  retained  and  one 
of  these  copies  should  have  a  place  printed  upon  it  for  enter- 
ing the  date  and  amount  of  invoices   received   applying 


HOW    TO     BEGIN    AN    AUDIT  55 

against  that  order;  thus  making  it  more  difficult  to  pass  a 
duplicate  invoice. 

A  careful  record  should  be  made  of  all  goods  received. 
In  some  of  the  larger  concerns  copies  of  orders  from  which 
the  quantities  and  prices  have  been  eliminated  are  sent  to 
the  receiving  clerk  for  his  information.  Then  upon  receipt 
of  the  goods  or  materials  the  receiving  clerk  enters  the 
quantities  and  sends  the  copy  of  the  order  to  the  accounting 
department  to  be  compared  with  the  invoices. 

If  the  person  in  charge  of  the  receipt  of  the  goods  is  not 
competent  to  pass  upon  the  quality  he  should  ask  for  the 
assistance  of  some  one  from  one  of  the  other  departments 
who  is  competent. 

The  operation  of  comparing  the  invoice  with  the  order, 
the  checking  of  quantities,  quality,  prices,  and  extensions 
should  be  indicated  by  the  initials  of  those  responsible  for 
each  operation  respectively. 

Before  being  sent  to  the  treasurer  for  payment,  invoices 
should  be  approved  by  the  executive  in  charge  of  the  ac- 
counting department;  and  when  the  cheque  is  drawn  this 
fact  should  be  noted  on  the  invoice  in  some  manner  to 
avoid  a  second  payment. 

If  the  voucher  system  of  payment  is  not  used,  the  stub 
of  the  cheque  should  show  sufficient  information  to  enable 
the  bookkeeper  to  identify  the  items  paid. 

The  accounts  payable  accounts  or  creditors  ledger  ac- 
counts should  be  balanced  at  regular  intervals. 

The  shipping  clerk  should  keep  a  separate  record  of  pur- 
chases returned,  and  this  record  should  be  systematically 
followed  up  to  secure  credit  from  the  original  shippers. 

Sales  Invoices 

The  quantities,  prices,  extensions,  and  additions  of  all 
sales  invoices  should  be  checked  at  least  once  before  the 


56  AUDITING 

invoices  are  sent  out.  This  checking  should  include  a  com- 
parison with  the  customer's  order  or  an  abstract  thereof. 

When  possible  the  duplicate  copy  method  of  writing  the 
sales  book  should  be  used,  the  first  carbon  copy  of  the 
invoice  becoming  the  sales  record.  This  gives  in  the  sales 
book  an  exact  copy  of  the  invoice  sent  out  and  is  admissible 
as  such  in  court. 

A  systematic  record  should  be  made  of  all  orders  re- 
ceived, and  as  shipments  are  made,  notation  to  that  effect 
should  be  made  on  these  records. 

The  receiving  clerk  should  keep  a  separate  record  of 
sales  returned,  which  record,  subject  to  the  approval  of 
some  one  in  authority,  should  be  the  basis  for  rendering 
credits  for  such  goods  to  customers. 

Customers'  Accounts 

As  stated  previously,  the  employee  in  charge  of  cash 
receipts  should  not  have  access  to  customers  ledgers. 

Allowances  should  not  be  made,  except  upon  written 
approval  of  proper  authority;  and  journal  entries  to  close 
off  accounts,  such  as  bad  accounts,  should  be  supported  by 
official  authorization. 

If  customers'  accounts  are  kept  in  subsidiary  ledgers,  the 
subsidiary  records  should  be  balanced  with  the  controlling 
account  at  regular  intervals. 

Collections 

Some  systematic  method  should  be  followed  in  the  col- 
lection of  accounts.  In  larger  concerns  this  should  be  in 
the  hands  of  a  separate  department,  and  in  any  case  it  should 
not  be  left  entirely  in  the  hands  of  the  bookkeeper. 

Pay-Roils 

The  method  of  preparing  the  pay-rolls,  should  be  such 
that  every  step  receives  an  independent  check  by  some  one 


HOW    TO    BEGIN    AN    AUDIT  57 

other  than  those  in  direct  charge  of  the  work.  A  record 
should  be  kept  of  the  name  and  rate  of  each  employee  and 
no  entries  should  be  made  on  this  record,  either  in  the  way 
of  additions  or  changes,  without  proper  authority,  which 
should  be  in  writing.  Payments  of  money  to  employees 
should  be  made  in  the  presence  of  two  or  more  persons  and 
both  the  paymaster  and  the  witness  should  sign  the  pay-roll 
sheets  to  evidence  the  payment. 

Stock  Records 

Where  practicable,  a  perpetual  inventory  of  stock  on 
hand  should  be  maintained  and  the  quantities  shown  by  this 
inventory  should  be  verified  from  time  to  time  by  comparison 
with  the  actual  goods  or  materials. 

Vacations 

Every  member  of  the  office  staff  should  be  required  to 
take  a  vacation  at  least  once  a  year,  and  it  is  also  advisable 
to  transfer  employees  from  one  position  to  another  at  more 
or  less  frequent  intervals,  dependent  upon  the  class  of  work 
which  they  perform. 

Branch  Office  Accounts 

Where  branch  offices  are  purely  sales  offices,  it  is  cus- 
tomary for  the  petty  expenses  of  the  office  to  be  paid  from  a 
petty  cash  fund  advanced  to  the  branch.  Reports  of  petty 
disbursements  accompanied  by  vouchers  are  sent  to  the  home 
office  periodically,  and  a  cheque  drawn  to  reimburse  the 
petty  cash  fund.  The  auditor  should  examine  these  reports 
and  the  vouchers  accompanying  them.  The  reports  should 
show  the  approval  of  the  person  in  charge  of  the  branch 
office,  and  in  some  cases  it  is  desirable  that  each  voucher 
show  proper  approval.  Cases  have  been  known  where  the 
amounts  of  express  bills  have  been  raised  by  office  boys 


58  AUDITING 

before  the  bills  were  presented  to  the  local  cashier  for  pay- 
ment. The  auditor  should,  of  course,  examine  very  closely 
any  bills  which  show  indications  of  erasures,  and  make  a 
further  investigation  if  the  facts  warrant. 

If  invoices  are  rendered  and  customers'  accounts  kept 
at  the  branch  office,  it  may  be  that  a  complete  system  of 
internal  check  will  make  it  unnecessary  for  the  auditor  to 
visit  the  branch  office,  although  these  cases  are  rare. 

Some  companies,  due  largely  to  the  nature  of  the  busi- 
ness, have  an  almost  infallible  check  on  their  branches.  A 
perpetual  inventory  of  all  goods  shipped  to  or  purchased  by 
the  branch  is  kept  at  the  home  office.  Copies  of  all  bills 
rendered  by  the  branch  are  sent  to  the  home  office,  where 
either  a  controlling  account  of  the  branch  customers  ledger 
or  a  duplicate  set  of  customers'  accounts  is  kept.  A  trial 
balance  of  the  branch  ledgers  is  sent  to  the  home  office  at  the 
end  of  each  month ;  copies  of  all  credits  rendered  and  journal 
entries  made  are  sent  to  the  home  office,  where  they  are 
carefully  inspected  before  being  approved.  Cash  collections 
are  deposited  in  a  local  bank  account,  over  which  the  branch 
has  no  control,  cheques  on  this  account  being  drawn  at  the 
home  office.  By  the  use  of  carbon  paper,  copies  are  made  of 
the  branch  office  cash  book  and  one  of  these  copies  is  sent 
to  the  home  office  each  day,  accompanied  by  signed  duplicate 
deposit  slips.  Statements  and  canceled  cheques  are  sent 
direct  to  the  home  office  by  the  local  bank ;  disbursements  for 
petty  expenses  at  the  branch  are  made  from  a  petty  cash 
fund  such  as  has  been  previously  described.  The  auditor's 
duty  in  cases  of  this  kind  should  be  to  see  that  the  system 
as  planned  is  carefully  carried  out  at  the  home  office,  making 
such  tests  as  may  be  necessary  to  satisfy  himself  in  this 
respect. 


CHAPTER    IV 

BALANCE    SHEET    AUDIT— ASSETS 

General  Principles 

The  underlying-  principles  of  a  balance  sheet  audit 
may  be  reduced  to  writing  and  are  not  subject  to 
change  to  fit  particular  businesses  or  special  systems  of 
account.  They  are  few  in  number  and  can  be  applied 
generally. 

The  principles  upon  which  all  balance  sheet  audits 
are  based  are  as  follows : 

1.  The  auditor  must  ascertain  that  all  of  the  assets 
shown  by  the  books  to  have  been  on  hand  at  a  certain 
date  were  actually  on  hand. 

2.  He  must  ascertain  whether  ^ny  other  assets,  not 
on  the  books,  should  have  been  on  hand. 

3.  He  must  ascertain  that  the  liabilities  shown  by  the 
books  to  be  owing  at  a  certain  date  were  actual  liabili- 
ties. 

4.  He  must  ascertain  whether  or  not  all  liabilities  were 
in  fact  shown  by  the  books. 

5.  He  must  ascertain  whether  or  not  the  liabilities  so 
shown  were  properly  incurred. 

In  the  following  pages  these  theories  will  be  discussed 
and  the  work  incident  to  a  balance  sheet  audit  will  be 
explained. 

59 


6o  AUDITING 

Limitations  of  Balance  Sheet  Audits  Must  be  Understood 

In  arranging  for  a  balance  sheet  audit,  the  distinction 
between  an  audit  of  that  character  and  a  detailed  audit 
should  be  pointed  out  to  the  client. 

It  sometimes  happens  that  after  a  balance  sheet  audit, 
specifically  provided  for  in  writing,  has  been  made  and 
the  report  rendered,  it  is  discovered  that  petty  defalcations 
have  been  going  on  for  a  long  time.  It  is  natural  for 
the  client,  in  such  event,  to  criticize  the  auditor,  but  if 
the  latter  has  a  written  order,  to  which  he  can  refer,  it 
can  be  clearly  shown  that  the  detection  of  the  small  theft 
was  not  within  the  scope  of  the  engagement.  If,  how- 
ever, the  auditor  has  been  careless  about  the  preliminary 
arrangements  and  has  not  explained,  nor  put  in  writing, 
the  limitations  of  a  balance  sheet  audit,  he  will  find  him- 
self in  an  embarrassing  position  and  is  fortunate  if  the 
worst  that  happens  is  the  loss  of  that  client. 

While  an  auditor  cannot  be  held  liable  in  money  dam- 
ages unless  negligence  is  proved,  yet  a  jury  might  find 
that  a  client  who  instructed  a  professional  auditor  to 
''make  an  audit,"  without  any  limitations  being  men- 
tioned, could  reasonably  expect  the  details  of  his  accounts 
to  be  fully  covered.  For  instance,  an  auditor  making  a 
balance  sheet  audit  would  rarely  prove  the  footings  of 
the  petty  cash  book;  but  if  it  were  aftenvards  found  that 
these  footings  had  been  systematically  overstated  and  the 
client  defrauded,  an  auditor's  freedom  from,  or  liability 
for,  negligence  might  rest  entirely  on  the  conditions  of 
his  employment. 

Assets 

One  definite  point  to  be  kept  in  mind  in  a  balance 
sheet  audit  is  that  an  entry  on  the  books  which  purports 
to  record  an  asset  is  nothing  rnore  than  a  book  record,  and 


BALANCE    SHEET    AUDIT— ASSETS  ^j 

there  can  be  no  good  excuse  for  accepting  such  entry  as 
final.  The  data  supporting  the  entry  may  be  in  order, 
but  it  is  the  auditor's  duty  to  verify  independently,  as 
far  as  possible,  the  fact  that  the  asset  still  exists,  or  did 
exist  at  the  date  of  the  balance  sheet. 

CURRENT  ASSETS 

The  current  assets  will  be  discussed  first.  These  are 
called  ''quick,'*  or  ''floating,"  or  "liquid."  The  author 
prefers  the  term  "current"  as  applied  to  all  of  those  assets 
which  are  for  sale.  If  any  doubt  exists,  it  can  be  settled 
by  the  answer  to  the  question:  Is  it  the  purpose  of  the 
business  to  convert  these  assets  into  cash  at  the  earliest 
practicable  moment? 

If  the  audit  occurs  some  time  after  the  closing  date, 
numerous  changes  are  apt  to  have  been  made  in  the  ctir- 
rent  assets  and  the  subsequent  entries  and  changes  will 
have  to  be  carefully  scrutinized,  for  the  light  they  may 
shed  on  the  past. 

At  the  outset  the  auditor  should  carefully  read  the 
schedule  of  assets  to  be  verified  and  outline  a  specific  plan 
which  has  for  its  basis  the  connection  between  the  entries 
supporting  the  asset  accounts  and  the  things  themselves. 
In  other  words,  all  of  the  assets  which  should  he  on  hand 
must  be  accounted  for,  including  those  on  the  books  and 
those  which  may  have  been  omitted  from  the  books. 

Liens  and  Hypothecations 

Throughout  the  verification  of  the  current  assets  the 
auditor  should  be  vigilant  in  his  endeavor  to  ascertain 
whether  the  title  to  the  accounts,  the  stock-in-trade,  the 
machinery  and  other  items  is  free  and  clear,  or  whether 
a  lien  exists  thereon  which  is  not  fully  disclosed  on  the 
books  and  in  the  financial  statements. 


62  AUDITING 

Insurance  policies  are  often  good  guides  to  title.  The 
holder  of  a  lien  on  merchandise  or  the  owner  of  a  chattel 
mortgage  is  usually  careful  to  protect  his  security,  and 
wherever  an  insurance  policy  is  payable  to  more  than  one 
party  ''as  their  interests  may  appear,"  the  auditor  is  put 
on  notice  that  the  property  insured  is  not  free  and  clear. 

There  is  a  tremendous  business  being  done  by  com- 
panies making  a  specialty  of  advances  upon,  or  the  pur- 
chase of,  accounts  receivable.  Some  of  these  companies 
solicit  business  upon  representations  that  the  transactions 
will  be  secret  and  that  no  information  relative  thereto  will 
be  available  to  the  customers  whose  accounts  are  assigned, 
or  to  the  creditors  whose  interest  in  such  accounts  receiv- 
able is  thus  subordinated  without  their  knowledge  or 
consent. 

In  many  cases  the  concerns  securing  the  advances 
have  greatly  benefited  thereby,  being  enabled  to  borrow 
in  this  way  enough  to  finance  their  businesses  properly : 
and  instances  are  known  where  concerns  so  financed 
have  thereby  escaped  bankruptcy  and  subsequently 
prospered. 

An  auditor,  therefore,  should  not  take  a  definite  stand 
for  or  against  the  practice  in  general,  but  he  should 
reserve  his  criticisms  for  abuses  or  objectionable  secrecy. 

The  absolute  necessity  for  disclosing  assignments  is 
pointed  out  on  page  272. 

It  may  be  that  an  effort  will  be  made  to  conceal  from 
the  auditor  the  transfer  of  the  accounts,  but  it  should 
not  be  dif^cult  to  find  some  trace  of  the  practice;  and.  if 
any  accounts  are  transferred  it  is  a  fair  assumption  that 
all  have  been. 

The  name  of  a  ''discount"  company  among  the  liabili- 
ties is,  of  course,  complete  notice  to  the  auditor,  but  the 
name  may  be  unfamiliar,   as  there  are   many  such   com- 


BALANCE    SHEET    AUDIT— ASSE'fS 


63 


panics  in  the  business.  The  safest  method  is  to  eliminate 
all  regular  trade  liabilities  and  investigate  the  origin  of 
the  others. 

Loans  other  than  from  banks  or  individuals  directly 
connected  with  a  concern  are  more  likely  than  not  to  be 
secured  by  collateral.  The  auditor  who  examines  the 
liabilities  with  this  assumption  in  mind  will  be  on  the 
safe  side. 

Usually  the  assignments  of  accounts  receivable  involve 
quite  a  lot  of  red  tape,  such  as  the  authorization  of  some 
one  in  the  borrowing  concern  to  collect  the  accounts  and 
remit  the  proceeds  to  the  "discount"  company;  the  prepa- 
ration of  schedules  of  accounts  assigned,  collected,  etc.; 
and  the  payment  of  bonuses,  commissions,  interest,  etc., 
at  rates  much  higher  than  the  usual  bank  rate. 

These  precautions  are  more  common  with  the  "non- 
notification" companies  than  the  others,  as  the  name 
implies  secrecy,  and  care  is  taken  that  customers  shall  not 
be  inadvertently  notified  that  their  accounts  have  been 
transferred  as  security  for  loans. 

In  many  cases  the  expenses  incident  to  the  as- 
signment of  accounts  receivable  can  be  avoided  and 
more  satisfactory  financing  arranged  for,  as  outlined  under 
"Acceptances,"  page  175. 

In  many  instances  goods  are  received  and  so-called 
trust  receipts  are  issued  in  connection  therewith.  These 
trust  receipts  usually  arise  out  of  importations  of  raw 
materials  shipped  sight  draft  against  bills  of  lading. 
Arrangements  are  then  made  with  bankers  to  pay  the 
drafts  and  release  the  goods  to  the  purchaser  in  trust, 
thus  creating  a  first  lien  thereon.  In  form  the  trust 
receipts  are  obligations  on  the  part  of  the  purchaser  to 
account  to  the  banker  for  the  proceeds  of  the  sale  of  the 
goods. 


64  •  AUDITING 

The  lien  of  a  trust  receipt  is  frequently  of  temporary 
effect  only,  because  the  goods  are  usually  taken  into  the 
purchaser's  warehouse  and  there  mingled  with  other 
goods,  thereby  making  it  practically  impossible  to  follow 
up  and  identify  the  merc4iandise.  When  the  materials 
require  manipulation  and  are  converted  into  other  forms, 
the  difficulties  of  identification  become  almost  insur- 
mountable. The  title,  therefore,  which  is  supposed*  to 
remain  in  the  name  of  the  banker,  becomes  of  little  value 
and  cannot  be  sustained  against  general  creditors.  There 
are,  however,  many  exceptions  where  the  goods  can 
be  readily  identified  and  where  the  title  remains 
unimpaired. 

In  all  cases  where  the  circumstances  surrounding 
purchases  indicate  the  possibility  of  trust  receipts 
having  been  issued,  the  auditor  will  have  to  be  most 
vigilant. 

The  author's  attention  has  been  called  to  numerous 
cases  where  balance  sheets  have  contained  no  reference 
to  existing  liens  of  this  nature.  If  a  concern  conceals 
an  important  fact  like  this  from  its  creditors,  there  is  a 
strong  likelihood  that  an  attempt  will  be  made  to  deceive 
the  auditor. 

The  head  of  on'ie  concern  which  failed  recently,  on 
being  asked  by  the  officer  of  a  certain  bank  whether  its 
secured  creditors  could  trace  the  merchandise  on  which 
they  had  made  large  advances,  said  laughingly,  "They 
think  they  can."  This  so  disgusted  the  banker  that  he 
immediately  withdrew  a  $100,000  line  of  credit  from  the 
applicant  and  told  him  that  he  could  not  borrow  a  cent 
there. 

Any  information  secured  relative  to  liens  or  encum- 
brances must  be  reflected  in  the  report  on  the  audit,  or 
on  the  face  of  the  balance  sheet  if  no  report  is  made.' 


BALANCE    SHEET    AUDIT— ASSETS  5e 

Proportion    of    Current   Assets   to    Other   Liabilities    and 
Capital 

The  rules  call  for  a  verification  of  the  assets  which 
are  on  hand  and  those  which  should  he  on  hand,  but  the 
latter  term  applies  to  physical  existence  only  and  does 
not  mean  that  the  auditor  must  necessarily  pass  upon  the 
propriety  of  the  aggregates  of  the  various  classes  of  assets. 
At  the  same  time,  in  order  to  be  as  valuable  as  possible  to 
a  client,  whether  a  borrower  or  a  banker,  the  auditor 
should  endeavor  to  determine  whether  or  not  the  relative 
proportions  of  cash,  accounts,  and  stock  compare  favor- 
ably with  those  of  the  most  successful  concerns  in  the 
same  line  of  business. 

This  thought  is  admirably  expressed  by  the  eminent 
banker,  Joseph  B.  Martindale,  President  of  the  Chemical 
National  Bank  of  New  York,  who  said  at  a  recent  Bankers' 
Convention: 

I  have  always  claimed  that  under  normal  business  conditions  a 
stated  amount  of  capital  (borrowed  as  well  as  invested)  should  allow 
a  concern  in  any  line  of  business  to  carry  a  certain  amount  of  mer- 
chandise. This  merchandise  later  is  converted  into  bills  and  accounts 
receivable;  later  on  into  cash;  and  upon  these  transactions,  subject  to 
the  charges  of  conducting  the  business,  there  should  be  realized  a 
certain  amount  of  net  profit.  All  of  these  items  in  a  well-organized 
and  well-conducted  business  should  be  in  relative  proportion  one  to  the 
other.  And  if  the  best  results  are  to  be  attained,  the  management  of 
any  concern  will  see  to  it  that  each  dollar  of  its  capital  carries  its 
proportion  of  merchandise,  and  will  also  see  to  it  that  the  merchandise 
is  moved  rapidly  and  converted  into  a  bill  or  account  receivable,  and 
that  its  outstanding  debts  are  promptly  collected,  and  that  its  cash  is 
used  to  reduce  materially,  or  entirely  liquidate,  its  indebtedness,  thereby 
saving  interest  and  expense.  We  have  in  a  number  of  instances  fol- 
lowed this  natural  sequence  in  business  and  have  found  any  number  of 
instances  where  each  dollar  of  capital  (invested  or  borrowed)  was  not 
performing  its  full  duty,  and  following  the  matter  still  further,  we 
found  it  due  to  either  extraordinary  expenses,  or  losses,  or  due  to 
indolence  and  a  lack  of  an  aggressive  policy  in  handling  the  affairs  of 
the  concern.    These  are  "earmarks"  which  will  denote  a  condition  of 


66  AUDITING 

this  kind,  and  we  believe  that  it  is  our  duty  to  examine  these  conditions 
thoroughly. 

As  an  illustration  of  this,  some  years  ago,  a  certain  firm  reported  in 
their  statement  an  invested  capital  almost  equal  to  the  amount  of  their 
annual  sales.  At  the  same  time  their  statement  showed  a  substantial 
liability  for  borrowed  money.  It  seemed  incredible  that  a  working 
capital  invested  and  borrowed  of  more  than  the  amount  of  the  annual 
sales  could  be  correct,  but  that  is  what  this  report  showed.  Upon 
closer  analysis  and  further  information,  it  was  found  that  in  the 
accounts  receivable  of  the  firm  there  were  many  old  accounts  running 
years  back,  which  they  were  carrying  as  good  accounts,  and  also  sub- 
stantial sums  due  the  firm  from  the  partners,  which  were,  in  other 
words,  overdrafts.  When  the  statement  was  all  boiled  down,  it  was 
found  that  their  actual  capital  was  less  than  one-half  that  reported 
in  their  statement.  These  are  the  "earmarks"  which,  upon  close 
observation  and  the  knowledge  of  credit,  prove  invaluable  to  one's 
institution. 

It  is  vitally  important  in  examining  and  passing  upon  a  statement 
that  one  should  be  thoroughly  familiar  with  the  conditions  surrounding 
the  business  during  the  year.  Conditions  may  have  made  it  impossible 
for  any  concern  to  make  money,  and  where  a  concern  reports  a  gain  in 
its  capital,  one  owes  it  to  himself  and  to  his  institution  to  inquire 
thoroughly  and  closely  as  to  the  causes  which  produced  such  a  result 
when  all  the  conditions  were  adverse. 

As  an  example,  we  have  the  accounts  of  a  number  of  houses  in  the 
same  interior  city  in  identically  the  same  line  of  business,  and  while 
the  amount  of  their  capital  varies  (and,  consequently,  their  volume  of 
business),  we  can  each  year,  by  working  out  the  percentages,  see  which 
concern  is  obtaining  the  best  results  upon  its  volume  of  business  and 
the  amount  of  its  capital. 

From  the  standpoint  of  good  banking  it  is  not  in  the  province  of 
any  bank  to  furnish  permanent  working  capital  for  any  one  of  its 
depositors.  A  bank  whose  liabilities  are  all  payable  on  demand  should 
observe  closely  the  well-established  rule  that  its  borrowers  should  at 
some  time  during  each  twelve  months  liquidate  their  indebtedness  to 
the  bank  for  a  reasonable  period  of  time.  In  my  opinion,  this  is  neither 
unjust  nor  arbitrary,  and  is  dictated  by  well-demonstrated  and  sound 
banking  and  business  logic. 

I  have  always  believed  that  an  independent  audit  by  a  firm  of 
certified  public  accountants  is  desirable.  And  from  the  standpoints  both 
of  the  borrower  and  the  lender,  it  is  wise  at  least  once  a  year  to  have 
the  affairs  of  a  firm  or  corporation  examined  and  audited  by  a  high- 
class  firm  of  auditors. 


BALANCE    SHEET    AUDIT— ASSETS  67 

It  is  obvious  that  no  concern  can  have  a  "dean  up" 
annually  or  oftener  unless  its  current  assets  are  susceptible 
of  being  turned  into  cash  within  a  reasonable  time.  There- 
fore, before  the  auditor  commences  his  verification  of  the 
current  assets,  he  should  ascertain  as  accurately  as  pos- 
sible the  normal  proportion  of  each  class  of  such  assets 
in  the  average  concern  in  the  same  line  of  business  as 
that  under  audit. 

With  this  as  a  starting  point  he  will  be  able  to  deter- 
mine, as  his  work  progresses,  how  far  from  normal  the 
concern  may  be,  and  an  opinion  so  formed  should  be  of 
the  greatest  possible  value  to  his  client. 

CASH 
Cash  in  Bank 

If  no  notice  has  been  given  txD  the  client's  stafif,  the 
cash  should  be  balanced  immediately,  the  bank  balances 
being  verified  by  independent  confirmation.  The  cash 
transactions  since  the  date  of  the  balance  sheet  should 
be  scrutinized  and  the  footings  proved  in  order  that  the 
balance  on  hand  as  stated  therein  may  be  shown  to  be 
correct. 

When  the  audit  occurs  a  considerable  time  after  the 
date  of  the  balance  sheet,  it  is  customary  to  secure  certifi- 
cates from  the  banks  covering  the  balances  as  of  the  clos- 
ing date.  These  are  reconciled  with  the  books,  accepting 
as  a  basis  the  schedule  of  outstanding  cheques  shown  by 
the  books. 

Many  auditors  accept  bank  pass-books  as  conclusive 
evidence,  but  the  author  has  encountered  several  cases  of 
fictitious  pass-books  and  two  cases  where  the  genuine 
pass-books  were  very  cleverly  altered.  Therefore,  to  be 
safe  the  auditor  should  have  one  of  his  own  staff  secure 
the  pass-books  or  statements  from  the  bank,  or  preferably 


68  AUDITING 

have  the  confirmation  of  the  balances  mailed  direct  to 
him  Jby  the  banks. 

The  auditor  should  satisfy  himself  that  the  cash  in 
banks  is  free  from  any  liens  or  offsets  and  may  be  with- 
drawn on  demand. 

The  auditor  may  very  properly  inquire  into  the 
average  balance  carried,  as  it  is  possible  that  the  concern 
is  overconservative  and  maintains  a  cash  balance  in  excess 
of  its  requirements.  If  all  purchases  are  discounted  and 
nothing  is  borrowed,  it  may  not  be  worth  while  to  criti- 
cize, but  instances  are  known  where  large  borrowers  have 
carried  cash  balances  considerably  in  excess  of  the  require- 
ments of  sound  business  financing.  The  cost  in  such  cases 
is  large  enough  to  attract  attention,  and  the  auditor 
should  tactfully  investigate  the  circumstances  leading  up 
to  the  custom.  It  may  be  found  that  those  in  charge  of 
the  finances  are  ignorant  of  the  general  usage,  in  which 
case  the  auditor  can  suggest  what,  in  his  opinion,  would 
represent  an  adequate  average  balance  to  be  maintained 
throughout  a  given  period. 

Auditors  of  broad  experience  frequently  suggest  that 
where  the  balances  in"  commercial  banks  are  larger  than 
necessary  to  secure  the  maximum  line  of  credit,  some 
funds  be  transferred  to  trust  companies  Where  interest  is 
allowed  on  inactive  accounts.  Some  of  the  largest  trust 
companies  now  accept  active  commercial  accounts  and 
even  allow  interest  on  daily  balances.  The  rule  with 
national  and  state  banks  is  by  no  means  uniform,  but 
many  of  them  allow  interest  to  desirable  depositors. 

Cash  on  Hand 

Where  the  petty  cash  balance  or  fund  called  for  by 
the  balance  sheet  is  small,  it  may  be  unnecessary  to- 
attempt  to  account  for  it,  as  it  might  require  considerable 


BALANCE    SHEET    AUDIT— ASSETS  69 

time  to  inspect  and  prove  all  of  the  entries  between  the 
closing  date  and  the  time  of  the  audit.  Usually  a  scrutiny 
of  the  subsequent  entries  will  be  sufficient. 

If  the  balance  is,  say,  over  $100,  it  had  better  be  veri- 
fied by  actual  count  and  proof.  In  an  English  case  an 
auditor  who  failed  to  verify  a  petty  cash  balance  of  nearly 
$4,000  was  held  to  have  committed  a  breach  of  duty.  The 
actual  balance  was  $150. 

The  balance  should  consist  of  actual  cash,  not  memo- 
randa or  "cash  items."  A  cashier  who  is  carrying  ques- 
tionable items  as  a  part  of  his  cash  balance  may  borrow 
money  enough  on  the  closing  date  to  enable  him  to  pay 
the  entire  balance  into  bank,  or  to  exhibit  the  cash  to  an 
executive;  after  doing  so  the  cashier  will  immediately 
put  the  items  back  into  the  cash  drawer  and  again  with- 
draw the  cash.  If  there  is  any  suspicion  that  this  is  being 
done,  a  second  count  of  the  cash  on  hand  should  be  made 
toward  the  close  of  the  audit. 

It  depends  on  the  auditor  whether  this  part  of  the 
work  proves  pleasant  and  satisfactory.  It  is  quite  possible 
that  an  auditor  will,  in  his  desire  to  jump  in  without 
notice,  really  upset  a  cashier  who  has  certain  routine 
methods  of  handling  the  cash  and  cash  records.  First 
impressions  are  very  important,  and  it  never  pays  to  dis- 
arrange the  work  of  a  single  person  in  a  client's  office 
unless  a  definite  reason  exists  for  proceeding  ofifhand  and 
without  giving  notice.  Where  the  client  does  not  inform 
his  staff  that  the  accounts  are  about  to  be  audited,  it  is, 
of  course,  desirable  for  the  auditor  to  take  advantage  of 
the  chance  to  surprise  the  man  in  charge  of  the  cash. 
Probably  more  petty  frauds  are  disclosed  in  this  manner 
than  in  any  other,  for  too  many  men  are  unable  to  dis- 
tinguish between  their  personal  funds  and  those  of  their 
employers.     Many  of  these  discrepancies  are  under  one 


JO 


AUDITING 


hundred  dollars,  and  if  the  cashier  were  given  time  to  put 
his  cash  drawer  in  order,  the  shortage  would  disappear. 
It  may  be  argued  that  in  such  a  case  no  great  harm  would 
ensue,  as  there  would  be  no  actual  rnoney  loss  to  the 
client.  No  greater  mistake  could  be  made,  however,  for 
a  man  whose  moral  sense  is  so  blunted  that  he  will  pilfer 
a  few  dollars  is  on  the  highway  to  further  frauds  and 
needs  only  a  good  chance  to  misappropriate  anything  of 
larger  value  on  which  he  can  lay  his  hands. 

In  practice  the  auditor's  appearance  is  usually  ex- 
pected. If  the  audit  is  a  periodical  one,  an  approximate 
time  of  commencing  is  known  in  advance,  and  if  it  is  a 
special  engagement,  in  most  cases  the  negotiations  with 
the  auditor  are  known  to  all  in  the  client's  office.  Here 
the  auditor  can  exercise  a  little  tact  or  diplomacy.  The 
cashier  may,  for  instance,  balance  his  cash  late  in  the  day, 
and  if  it  is  much  of  a  task  he  will  be  anxious  to  hurry  oflf 
home  upon  the  striking  of  a  balance.  The  wise  auditor 
will  make  it  a  point  to  tackle  him  first  thing  in  the  morn- 
ing at  a  time  when  the  memoranda  of  the  day  have  not 
commenced  to  accumulate  and  when  the  cash  book  is  written 
up  and  the  footings  shown. 

Very  often  slips  of  paper,  tickets,  and  so-called  vouch- 
ers will  make  up  a  large  portion  of  the  ''cash"  in  the 
drawer.  In  all  cases  count  the  actual  money  first  and 
then  list  the  memoranda.  This  record  should  be  full  and 
complete,  for  there  may  be  some  delay  before  it  is  used 
again,  and  cases  have  been  known  where  unauthorized 
tickets  carried  as  cash  have  mysteriously  disappeared 
immediately  after  an  auditor's  count  of  the  drawer. 

If  there  is  a  difference  between  the  amount  on  hand 
and  the  balance  called  for  by  the  cash  book  or  the  round 
sum  carried  in  the  ledger  as  a  petty  cash  fund,  it  is  not 
wise  to  assume  at  once  that  there  is  something  wrong. 


BALANCE    SHEET    AUDIT— ASSETS  71 

The  auditor  should  note  the  cash  book  footings,  and 
with  this  information  in  his  possession,  together  with  his 
count  of  the  cash  drawer,  he  can  afford  to  give  the  cashier 
a  chance  to  hunt  for  the  difference.  If  the  cashier  bal- 
anced the  night  before,  the  error  may  be  in  the  auditor's 
own  figures.  If  a  shortage  exists,  it  should  develop  at 
this  point. 

When  the  cash  balance  consists  of  several  bank  ac- 
counts or  funds,  care  must  be  taken  to  see  that  the  entire 
balance  is  verified  simultaneously.  Instances  are  known 
where  auditors  have  been  deceived  through  one  balance, 
after  being  inspected,  having  been  transferred  and  used 
on  a  later  day  in  connection  with  another  balance. 

ACCOUNTS  RECEIVABLE 
Trade  Debtors 

In  a  long-established  business  where  the  sales  are 
fairly  constant,  the  accounts  can  be  valued  on  a  basis 
of  past  results.  Ascertain  the  percentage  of  bad  accounts 
in  past  years  and  apply  this  percentage  to  all  sales  up 
to  the  closing  date.  The  sales,  for,  say,  the  last  month, 
should  be  scrutinized  (not  footed)  in  order  to  ascertain 
whether  or  not  there  is  any  evidence  of  predating,  billing 
to  fictitious  customers,  or  including  consigned  goods  or 
goods  sent  on  approval  as  sales  at  full  prices. 

Consigned  goods  may  be  included  among  the  current 
sales  in  good  faith,  if  it  has  been  the  custom  of  the  con- 
cern to  do  so,  but  this,  of  course,  does  not  justify  the 
practice,  which  results  in  anticipating  profits  that  have 
not  been  earned. 

Accounts  current  should  be  obtained  for  all  consign- 
ment accounts,  and  any  unsold  goods  at  time  of  closing 
should  be  added  to  the  inventory  and  priced  at  cost  or 
market,  whichever  is  the  lower.    If  the  goods  are  salable 


72  AUDITING 

and  practically  sure  to  be  sold,  accrued  charges  thereon 
may  be  added  to  the  inventory  prices. 

If  past  experience  is  not  available  the  outstandings 
will  have  to  be  valued  on  their  merits,  because  the  auditor 
cannot  hope  to  have  reliable  statistics  of  other  concerns 
or  for  a  series  of  years  upon  which  to  base  his  conclusions. 
The  auditor  of  experience  will  have  a  general  familiarity 
with  the  normal  volume  of  outstandings  which  various 
classes  of  business  may  be  expected  to  carry,  and  he  should, 
for  his  own  information,  compare  the  relative  outstandings 
of  each  business  to  the  gross  sales,  and  of  different  con- 
cerns in  the  same  line  of  business.  The  value  of  such  a 
comparison  may  be  apparent  at  a  glance,  and  negligence 
and  laxity  may  stand  revealed  which  might  not  be  ap- 
parent in  a  routine  audit.  The  best  method  of  collating 
such  data  is  to  compile  statistics  covering  gross  and  net 
figures  and  the  percentages  produced  thereby,  at  the  close 
of  each  audit.  In  the  course  of  time  a  vast  quantity  of 
information  will  be  at  hand  and  available  at  a  moment's 
notice'for  comparative  purposes. 

When  the  list  of  open  balances  is  compared  with  the 
sales  ledgers  it  should  be  noted  'that  the  balances  are 
represented  by  specific  invoices  of  a  recent  date;  other- 
wise the  balances  should  be  analyzed.  An  old  item  in  a 
running  account  or  a  bill  partly  paid,  followed  by  others 
fully  paid,  usually  means  that  an  allowance  has  been  or 
will  be  made,  or  that  a  defalcation  exists. 

Schedules  should  be  made  of  all  overdue  accounts 
classified  according  to  age.  Those  quite  old  cannot  be 
considered  as  worth  anything  unless  a  very  strong  argu- 
ment is  presented,  supported  by  documentary  evidence.     . 

It  is  a  rule  of  law  that  assent  to  the  correctness  of  a 
balance  may  be  inferred  from  retaining  an  account  ren- 
dered without  objection  within  a  reasonable  time,  and 


BALANCE    SHEET    AUDIT— ASSETS  73 

the  burden  of  impeaching  the  accuracy  of  the  account, 
for  fraud  or  mistake,  is  cast  upon  the  party  complaining 
of  the  balance,  but  the  only  proper  test  of  ability  to  pay  is 
payment,  and  where  this  is  delayed  an  unreasonable  length 
of  time,  the  inference  is  that  "ability  to  pay"  is  lacking. 

Accounts  ranging  from  long  overdue  to  those  just 
over  the  ''net"  pei-iod  should  be  depreciated  as  may  be 
determined  after  proper  inquiry  has  been  made. 

The  auditor  must  ascertain  whether  any  accounts  have 
been  pledged  or  assigned.  This  is  frequently  done  with- 
out any  record  being  made  in  the  books. 

The  following  suggestions  will  be  found  useful  in  fix- 
kig  a  valuation  upon  trade  accounts  which  are  overdue: 

1.  Have  the  terms  of  credit  been  habitually  ignored? 
Even  so,  the  debtors  may  be  perfectly  good,  but  such 
accounts  should  have  special  attention  from  the  credit 
manager. 

2.  If  payments  on  account  are  being  made,  is  the  bal- 
ance being  increased  or  decreased?  If  the  former,  this  is 
prhna  facie  evidence  that  debtor  is  approaching  the  time 
when  all  payments  will  stop.  This  is  a  class  of  account 
which  deserves  more  attention  than  it  receives.  The 
auditor  should  keep  this  point  in  mind,  and  a  word  of 
advice  from  him  may  save  ultimate  loss.  Salesmen  relin- 
quish these  accounts  very  reluctantly,  but  they  are  not 
the  best  authorities  on  the  ability  of  a  debtor  to  pay. 

3.  If  credit  has  been  stopped  and  no  recent  collections 
appear,  ascertain  if  account  has  been  placed  with  attor- 
neys for  collection. 

4.  If  in  hands  of  attorneys,  ask  for  correspondence. 
Accounts  are  frequently  placed  with  lawyers  who  are  not 
equipped  for  collection  business  and  who  do  not  keep 
after  the  debtors.  Unless  frequently  checked  up,  the 
debtor  will  not  pay.     So  long  as  his  money  lasts,  or  he 


74 


AUDITING 


desires  to  preserve  his  credit,  a  debtor  will  pay  those  who 
press  him  the  hardest. 

5.  If  a  debtor  who  has  paid  cash  commences  to  give 
notes,  ascertain  if  a  sound  reason  therefor  has  been 
offered  and  whether  the  change  has  been  approved  by 
some  one  in  authority. 

In  all  except  the  rarest  cases,  those  in  charge  of  the 
outstandings  will  be  found  to  be  optimistic  to  an  unrea- 
sonable and  undependable  degree.  Nevertheless,  their 
knowledge  must  be  utilized  by  the  auditor,  who  can  dis- 
count their  estimates  as  much  as  seems  necessary  and 
finally  draw  his  own  conclusions. 

A  certificate  as  to  outstandings  ought  not  to  be  given 
unless  the  schedules  of  accounts  have  been  compared  in 
detail  with  the  customers  ledgers,  and  the  footings  of  the 
schedules  verified.  The  procedure  in  this  case  should  be 
the  same  whether  or  not  a  controlling  account  is  kept, 
except  that  this  rule  may  be  modified  in  the  case  of  a 
concern  having  a  very  large  number  of  open  accounts 
which  are  subject  to  internal  check. 

Discounts  which  will  be  deducted  by  customers  and 
which,  while  called  cash  discounts,  are  greater  than  a  con- 
cern would  pay  for  the  use  of  money,  must  be  allowed 
for.  In  a  stable  business  it  is  usually  possible  to  deduct 
a  fixed  percentage  from  all  the  outstandings.  Where 
special  discounts  are  given,  it  may  be  necessary  to  classify 
the  balances  before  determining  the  deductions  to  be 
made.  If  freight  allowances  are  permitted,  care  must  be 
taken  to  see  that  adequate  provision  is  made  therefor. 

Miscellaneous  Receivables 

The  foregoing  comments  refer  to  what  are  known  as 
trade  debtors  and  apply  chiefly  to  mercantile  and  manu- 
facturing concerns.    The  same  principles  govern  the  veri- 


BALANCE    SHEET    AUDIT— ASSETS  7- 

fication  of  the  outstandings  in  enterprises  which  are  not 
generally  classified  as  mercantile  or  manufacturing. 

For  instance,  real  estate  agents,  as  well  as  manufac- 
turing establishments,  may  show  on  their  balance  sheets 
large  items  which  represent  real  estate  rentals  uncollected. 
Likewise,  stock-brokers  carry  very  large  items  of  assets 
which  represent  balances  due  by  customers.  The  balance 
sheets  of  financial  institutions,  and  of  enterprises  where 
investment  securities  are  owned,  will  contain  items  of 
interest  and  dividends  due,  but  not  collected.  The  bal- 
ance sheets  of  commission  houses  will  show  commission 
and  other  charges  as  accounts  receivable. 

In  all  cases  the  auditor  must  satisfy  himself: 

(a)  That    the   items   constituting   the   balances   are 

bona  fide,  and 

(b)  That  the  balances  have  not  been  liquidated  in 

part  or  in  whole. 
The  means  of  verifying  these  requiremen<ts   do  not 
differ  in  principle  from  the  rules  enumerated  for  testing 
the  accuracy  of  balances  due  from  trade  debtors. 

Fictitious  Accounts  Receivable 

In  many  balance  sheets,  accounts  receivable  from  cus- 
tomers are  mingled  with  other  debit  balances.  The  latter 
may  include  advances  to  salesmen  and  others;  overdrafts 
of  officers;  claims  against  railroads,  creditors,  or  the  gov- 
ernment for  alleged  overcharge  of  duties;  prepayments 
on  purchase  contracts;  guarantees;  etc.  Not- infrequently 
considerable  amounts  will  be  included  which  represent 
charges  to  vendors  for  goods  returned.  Such  balances  are 
rarely  settled  in  cash.  Where  the  open  items  consist  of 
cash  debits,  it  may  be  assumed  that  purchase  invoices 
exist  which  have  not  yet  been  credited  to  the  account. 
The  distinction  to  be  drawn  here  is  that  instead  of  dealing 


76  AUDITING 

with  the  accounts  in  groups,  each  individual  account  must 
be  scrutinized  and  valued  on  its  merits. 

Sometimes  these  so-called  accounts  receivable  are  not 
"receivable"  at  all,  but  are  merely  advances  under  con- 
tracts where  the  goods  or  materials  purchased  were  not 
delivered  at  the  date  of  the  balance  sheet.  One  experi- 
ence of  the  author's  will  illustrate  this  point. 

An  iron  company  was  under  contract  to  purchase  large 
quantities  of  ore  and  to  make  periodical  payments  irre- 
spective of  actual  deliveries,  except  that  the  ore  was  all 
to  be  delivered  within  one  year.  After  the  payments  com- 
menced and  before  any  ore  was  received,  its  books  were 
closed.  The  payments  were  included  among  the  regular 
accounts  receivable  in  the  balance  sheet.  The  author 
separated  the  items  and  set  up  a  new  balance  sheet  show- 
ing the  advances  under  their  proper  caption. 

The  balance  sheet  was  to  be  used  as  a  basis  of  credit, 
and  a  banker  or  creditor  would  have  been  grossly  deceived 
if  the  adjustment  had  not  been  made,  as  the  item 
''accounts  receivable"  in  a  balance  sheet,  stated  without 
modification,  indicates  one  of  the  best  quick  assets, 
whereas  in  this  case  not  one  cent  could  be  realized  on  this 
item  until  the  ore  was  shipped  and  received,  converted 
into  iron,  the  iron  sold,  and  the  proceeds  collected.  In 
other  words,  it  was  a  deferred  asset  of  the  most  extreme 
kind. 

The  president  of  the  company  strenuously  objected 
to  the  restatement  of  the  balance  sheet,  saying  that  it  had 
always  been  done  in  the  old  way  and  that  the  change,  if 
made,  would  attract  unfavorable  attention. 

While  changes  in  the  form  of  annual  statements  due 
to  previous  erroneous  practices  are  always  to  be  regretted, 
nevertheless  it  is  clear  that  the  facts  must  be  shown 
when  they  are  known.     In  this  instance  the  balance  sheet 


BALANCE    SHEET    AUDIT— ASSETS  ^j 

was  restated  in  correct  form,  and  has  been  so  stated  from 
that  time. 

In  another  instance  a  silk  merchant  had  made  ad- 
vances to  a  manufacturer.  These  advances  amounted  to 
several  hundred  thousand  dollars  and  were  included  in 
the  aggregate  of  his  accounts  receivable  without  any 
explanation.  He  had  secured  a  large  line  of  credit  based 
chiefly  on  his  outstandings. 

Investigation  disclosed  the  fact  that  the  advances 
carried  with  them  the  ownership  of  several  mills  which 
were  being  conducted  at  a  loss,  so  that  the  accounts, 
instead  of  being  current  accounts  receivable  worth  their 
face  value,  represented  real  estate,  machinery,  raw  mate- 
rial, manufactured  and  finished  goods,  the  highest 
total  value  of  which  fell  far  short  of  the  aggregate 
advances. 

In  a  recent  bankruptcy  case  it  was  found  that  among 
the  accounts  receivable,  as  theretofore  carried  on  the 
balance  sheet,  there  was  an  item  of  $58,000,  representing 
the  amount  of  an  embezzlement  by  an  employee  seven 
years  previously.  Part  of  the  time  the  account  wa?  trans- 
ferred from  ''accounts  receivable"  to  investments.  It  was 
explained  that  it  was  the  intention  of  the  company  to 
reduce  the  amount  each  year  from  the  profits  until  the 
entire  sum  was  cleaned  up.  It  certainly  required  a  vivid 
imagination  to  call  this  item  a  quick  asset! 

The  caption  ''Accounts  Receivable"  is  sometimes  used 
to  cover  deferred  charges  to  operating,  such  as  rents  paid 
in  advance  and  similar  items.  In  no  sense  of  the  word 
are  these  accounts  receivable.  The  test  is:  Will  the  bal- 
ances be  liquidated  in  cash  in  due  course?  Of  course 
nothing  will  be  realized  by  a  going  concern  from  such 
accounts,  and  in  the  case  of  a  liquidation  no  funds  arising 
therefrom  will  be  available  for  the  payment  of  debts. 


78 


AUDITING 


Deposits 

Another  class  of  items  sometimes  mingled  with  the 
current  assets  is  that  of  cash  deposits  put  up  as  security 
under  a  lease  for  the  faithful  performance  of  a  contract;^ 
as  security  for  costs,  etc.,  in  an  appeal  to  a  higher  court; 
by  agents  Who  have  ordered  goods  in  advance,  such  as 
automobiles;  with  public  utility  companies,  etc.,  eto. 

In  all  of  these  cases  and  many  others  the  proprietors 
of  a  going  business  feel  that  the  cash  so  paid  out  is  a 
good  asset.  Frequently  they  either  count  on  getting 
back  the  cash  itself  or  they  know  that  the  deposits  will 
be  applied  on  purchases. 

In  the  former  case  the  cash  may  be  returned,  but  the 
period  of  realization  is  most  uncertain  and  cannot  be  de- 
pended upon  as  a  source  of  funds  available  for  other  pur- 
poses than  the  special  one  for  which  the  deposit  was 
made.  The  landlord  who  holds  a  cash  deposit  as  security 
under  a  lease  will  probably  require  the  same  or  a  larger 
amount  upon  renewal.  If  there  is  no  renewal,  he  may 
hold  deposits  for  several  years  pending  the  settlement  of 
a  claim  for  injury  to  the  premises. 

In  the  latter  case  it  is  true  that  the  deposits  will  be 
applied  on  purchase  contracts,  but  this  is  in  efifect  a  pre- 
payment and  no  cash  will  be  returned  which  can  be  paid 
to  other  creditors. 

For  all  practical  purposes,  therefore,  these  items  are  a 
part  of  the  fixed  or  deferred  assets  and  furnish  very  poor 
security  for  unsecured  creditors. 

Verification  of  Outstandings  by  Correspondence 

There  is  but  one  absolute  method  of  ascertaining  the 
accuracy  of  the  aggregates  shown  on  the  balance  sheet 
as  due  from  trade  and  other  debtors,  and  that  is  to  pro- 
cure an  acknowledgment  of  the  debt  from  the  debtor. 


BALANCE    SHEET    AUDIT— ASSETS 


79 


This,  of  course,  is  impracticable  in  most  cases,  but  wher- 
ever the  opportunity  affords,  the  auditor  should  verify 
the  correctness  of  the  outstandings  by  requesting  con- 
firmations by  direct  correspondence  with  the  debtors. 
This  subject  is  discussed  more  fully  on  page  319  hereof. 


CHAPTER    V 

BALANCE    SHEET    AUDIT— ASSETS     (Continued) 


CURRENT  ASSETS   (Continued) 

Notes   Receivable 

This  account  ought  to  include  unmatured  notes  only, 
free  from  liens. 

In  almost  all  respects  the  valuation  of  notes  receivable 
should  be  made  along  the  lines  indicated  for  accounts 
receivable. 

In  some  trades  notes  are  given  by  concerns  of  the 
very  highest  standing,  as,  for  instance,  in  the  silk  and 
jewelry  trades.  In  other  lines,  as,  for  instance,  the  auto- 
mobile and  grocery  trades,  notes  are  considered  a  sign  of 
weakness..  The  first  consideration,  therefore,  must  be 
as  to  the  custom  of  the  particular  business  under  review. 
If  it  is  usual  to  accept  notes  from  first-class  debtors,  the 
notes  will  be  valued  in  the  same  manner  as  book  accounts. 
(See  page  71.) 

If  notes  have  been  accepted  from  other  than  trade 
debtors,  or  if  it  is  not  the  general  custom  of  the  trade 
to  give  notes,  then  each  individual  note  must  be  valued 
on  its  merits.  The  examination  should,  of  course,  cover 
notes  under  discount  as  well  as  those  on  hand.  The 
former  should  be  verified  by  correspondence  with  the 
bankers,  or  by  inspection  of  the  discount  records,  and  the 
latter  by  actual  inspection.  Inspection,  however,  must 
not  be  confined  to  an  examination  and  listing  of  notes  on 
hand,  as  part  thereof  may  have  been  paid;  or  if  overdue 
and    ostensibly    still    carried    in    the    notes    receivable    ac- 

80 


BALANCE    SHEET    AUDIT— ASSETS  gl 

count,  they  may  have  been  charg'ed  back  to  the  makers' 
individual  accounts.  Care  should  be  taken,  therefore,  to 
reconcile  each  note  comprising  part  of  the  notes  receiv- 
able ledger  account  with  the  notes  themselves,  or  either 
satisfactory  records. 

The  balance  sheet  should  show  the  notes  under  dis- 
count, as  a  contingent  liability  therefor  exists.  They 
represent  an  asset,  hypothecated  as  it  were,  against  which 
a  loan  has  been  secured  from  the  bank,  therefore  the 
aggregate  under  discount  should  appear  as  a  footnote 
on  the  liability  side  of  the  balance  sheet. 

Instances  have  been  known  where  notes  for  large 
sums,  but  with  makers  of  little  responsibiHty,  have  been 
discounted  and  renewed  as  long  as  the  banks  would  take 
them.  Where  the  facts  are  not  known  and  several  bank 
accounts  are  kept,  it  is  comparatively  easy  to  shift  dis- 
counts from  one  bank  to  another. 

It  is  obvious  that  such  notes  are  in  reality  notes 
payable.  The  auditor  is  not  justified  in  certifying  to  the 
balance  vsheet  item  of  notes  receivable  unless  he  believes 
that  all  of  the  notes  will  be  paid  when  due,  or  unless  a 
sufficient  reserve  is  created  to  cover  probable  losses  in 
realization. 

Where  notes  have  not  been  paid  at  maturity,  they 
should,  as  stated  above,  be  taken  out  of  the  notes  receiv- 
able account,  as  the  latter  account  should  represent  un- 
matured notes  only.  It  might  be  feasible  to  carry  dis- 
honored notes  in  a  separate  account,  but  it  is  considered 
proper  accounting  practice  to  debit  the  personal  account 
of  the  debtor  with  the  amount  of  the  note  and  the  protest 
fees  and  include  the  debt  among  those  of  the  class  to 
which  it  belonged  before  it  was  converted  from  an  account 
into  a  note  receivable. 

Thus  if  a  grocer  sold  sugar  to  a  customer,  took  a 


82  AUDITING 

note  for  the  amount  of  the  sale,  was  unable  to  collect 
when  due  and  charged  the  note  and  protest  fees  back  to 
the  customer's  account,  then  he  would  include  the  new 
balance  among  other  trade  debtors.  This  is  the  proper 
way  to  handle  the  transaction.  The  auditor,  in  valuing 
the  accounts,  will  estimate  the  actual  worth  of  this  ac- 
count, taking  into  consideration  the  facts  as  shown 
on  its  face. 

Protested  notes  are  frequently  paid  thereafter,  but 
they  cannot  be  classed  with  accounts  not  due,  nor  with 
those  overdue  from  chronic  slow  payers.  The  maker  of  a 
note  who  fails  to  meet  his  obligation  at  maturity  is  never 
a  desirable  customer,  and  in  the  long  run  subsequent 
credit  extended  to  such  customers  invites  ultimate  loss. 

There  are  exceptions  to  this  rule  in  the  case  of  such 
concerns  as  agricultural  implement  manufacturers  where 
it  is  the  custom  to  take  notes  for  a  large  part  of  the  sales, 
and  many  are  not  paid  during  years  of  crop  failures. 
These  overdue  notes  are  considered  almost  as  collectable 
(so  far  as  ultimate  realization  is  concerned)  as  the  un- 
matured ones,  and,  as  it  is  more  convenient  for  the  collec- 
tion department  to  handle  them  as  notes  than  as  part  of 
open  accounts,  they  are  not  charged  back  to  the  custom- 
er's accounts. 

Under  such  circumstances  in  stating  the  item  ''Notes 
Receivable"  in  the  balance  sheet,  the  auditor  may  not 
consider  it  necessary  to  separate  the  overdue  and  not  due 
notes,  but  he  should  be  sure  that  one  class  is  as  good 
as  the  other,  or  that  a  sufficient  reserve  has  been  created 
for  the  probable  loss. 

Stock  Subscriptions 

The  uncollected  balances  due  from  stockholders  in 
respect  to  their  subscriptions  to  the  capital  stock  of  a 


BALANCE    SHEET    AUDIT— ASSETS  83 

coq)ora'tion  are  unSbubtedly  accounts  receivable,  but  it  is 
not  considered  proper  to  include  such  balances  with  the 
receivables  of  any  other  class.  The  reason  for  this  is 
obvious.  If  the  subscriptions  are  overdue,  the  fact  of 
their  non-collection  indicates  poor  management  or  unde- 
sirable stockholders.  If  not  due,  it  affords  those  who  use 
the  balance  sheet  an  opportunity  to  inquire  into  the  finan- 
cial standing  of  the  debtors.  If  good,  it  not  only  means 
that  a  certain  amount  of  liquid  capital  will  be  forthcoming 
at  a  certain  date,  but  it  furnishes  evidence  that  the  capital 
stock  is  being  paid  for  in  cash,  and  is  reassuring  as  to  the 
future,*  because  the  connection  of  financially  responsible 
stockholders  with  a  company  usually  means  that  they 
are  prepared  to  stand  by  it  and  protect  their  interests. 

Instalment  Contracts 

In  several  lines  of  business  sales  are  made  or  contracts 
ar6  executed  under  conditions  which  require  time  to  con- 
summate, or  which  are  payable  in  instalments.  It  is  cus- 
tomary to  charge  the  total  contract  to  the  debtor  and 
credit  the  collections  on  account  as  they  are  made. 
Experience  has  demonstrated  that  many  of  these  con- 
tracts are  not  carried  out,  in  which  case  the  balances  due  are 
uncollectlible.  If  a  business  has  been  established  for  a 
number  of  years,  past  results  can  be  used  as  a  guide  in 
valuing  the  outstandings,  but  where  the  business  has 
been  recently  established,  great  care  must  be  taken.  The 
first  point  to  consider  is  the  character  of  the  contract  and 
description  of  the  subject  matter. 

In  the  case  of  piano  contracts  where  a  material  first 
payment  is  collected,  and  where  the  piano  can  be  taken 
back  without  excessive  cost,  the  loss  would  be  small;  but 
the  reverse  is  the  case  with  the  class  of  contracts  for 
correspondence  courses  and  books.     It  is  not  usually  con- 


g4  AUDITING 

sidered  worth  while  to  attempt  to  reclaim  books  and 
lesson  papers,  although  title  does  not  pass  until  the  final 
payment  is  made,  nor  is  it  usually  worth  while  to  enter 
suit  for  collection  of  the  balance  due.  Therefore,  in  all 
cases  where  this  class  of  contracts  is  entered  at  the  full 
purchase  price,  a  considerable  reserve  must  be  provided 
for  bad  debts. 

INVENTORIES 

Raw  Materials,  and  Stock  Purchased  to  be  Resold  in  the 
Same  Form 

Under  this  caption  should  be  included  only  stocks  of 
goods  owned  and  under  the  coxitrol  of  the  owner.  Stocks 
are  often  hypothecated,  and  if  this  is  the  case,  the  fact 
should  be  stated  on  the  face  of  the  balance  sheet. 

The  basis  of  value  should  be  cost  or  market,  which- 
ever is  the  lower.  If  purchases  have  been  made  on  a  falling 
market,  it  is  not  consei-vative  to  place  a  higher  value  on 
an  inventory  item  than  the  price  at  which  the  same  thing 
can  be  duplicated  in  the  open  market.  It  deceives  the 
banker,  creditor,  and  stockholder,  who  have  a  right  to  be- 
lieve that  the  values  stated  are  real  values  as  of  the  date 
of  the  balance  sheet. 

It  may  seem  inconsistent  to  advocate  a  somewhat 
different  principle  when  purchases  have  been  made  on  a 
rising  market  and  where  the  goods  cannot  be  duplicated, 
except  at  a  higher  price.  In  this  case,  however,  'the  con- 
servative course  is  to  carry  the  items  at  cost  and  thus  do 
away  with  the  objectionable  practice  of  anticipating  a 
profit. 

In  this  connection  raw  materials  are  dealt  with  as 
being  the  first  stage  of  a  manufacturing  pwocess.  If 
bought  and  sold  without  alteration  in  form,  there  is  some 
merit  in  the  contention  that  the  difference  between  cost 


BALANCE    SHEET    AUDIT— ASSETS 


85 


and  market  is  a  loss  or  gain  properly  applicable  to  the 
period  preceding  the  closing  of  the  books,  but  the  fact, 
nevertheless,  remains  that  the  goods  in  the  inventory 
have  not  been  sold  and  no  profit  has  been  earned. 

The  safest  rule  is  the  better  one  to  follow,  and  this  is 
unquestionably  cost  or  market,  whichever  is  the  lower.  If 
the  market  is  higher  than  cost,  and  cost  is  used,  it  is 
quite  in  order  to  indicate  this  fact  (if  it  is  important)  in 
a  footnote  on  the  balance  sheet,  and  no  criticism  will 
follow,  whereas  bankers  are  never  pleased  to  learn  that  an 
inventory  has  been  marked  up  and  a  profit  taken  which 
is  not  yet  realized. 

The  physical  condition  and  salability  of  the  stock  must 
also  be  considered.  If  there  is  deterioration  or  if  part  of 
the  stock  is  out  of  date,  or  otherwise  unsalable,  the  asset 
loses  its  most  important  aspect,  availabiUty.  This  is  a 
most  difficult  fact  for  the  auditor  to  determine,  but  he 
must  depend  upon  his  own  intuition  and  inquiries  to  de- 
termine whether  or  not  the  stock  is  in  good  condition  or 
merchantable,  supplementing  this,  of  course,  by  certifi- 
cates from  those  in  charge  of  the  departments  concerned 
covering  this  point  fully. 

The  price  placed  upon  raw  materials  can  be  checked 
in  nearly  all  cases  by  recent  purchase  invoices,  while  with 
all  staple  goods  reports  as  to  current  values  are  readily 
obtainable. 

The  extensions  should  be  tested  and  all  large  items 
scrutinized.  Exceptionally  large  quantities  of  particular 
items  deserve  special  inquiry,  and  some  general  familiarity 
with  the  normal  stock,  which  any  well-conducted  concern 
in  the  same  line  of  business  should  carry,  is  very  desirable. 

The  footings,  ttoo,  should  be  verified,  or  at  least  be 
thoroughly  tested.  Many  instances  have  been  found 
where  serious  errors  have  existed  in  both  calculations  and 


86  AUDITING 

footings,  so  that  an  auditor  who  fails  to  cover  this  point 
fully  is  open  to  criticism. 

In  a  celebrated  English  case  it  was  held  by  the  court 
that  an  auditor  is  not  a  valuer;  that  it  is  not  his  duty  to 
take  stock;  that  in  the  absence  of  suspicious  circumstances 
he  is  entitled  to  rely  upon  the  representations  of  respon- 
sible officials;  and  that  he  is  not  guilty  of  negligence  if  he 
accepts  the  certificate  of  such  persons  to  the  value  of  the 
stock-in-trade. 

The  auditor's  course,  therefore,  is  to  secure  all  the 
evidence  within  his  power  to  demand,  and  lacking  any 
part  of  the  proof  which  he  deems  necessary,  his  only 
course  is  to  qualify  his  certificate  accordingly. 

The  author  thinks  the  accountants  in  England  rely 
too  much  on  the  decision  of  a  Lord  Chief  Justice  that  the 
auditor  ''is  not  called  upon  to  be  suspicious,  nor  even  to 
make  inquiry,  provided  that  nothing  comes  to  his  notice 
to  cause  him  to  think  that  there  is  need."  This  may  be 
law,  but  it  is  a  poor  rule  to  insert  in  an  audit  program. 

It  may  be  that  the  borrowers  and  debtors  in  the  United 
States  overstate  their  inventories  and  deceive  their  cred- 
itors to  a  greater  extent  than  is  the  case  in  England,  in 
which  case  an  auditor  there  may  be  justified  in  accepting 
the  certificate  of  some  one  else  as  the  sole  check  on  the 
stock,  but  the  auditor  here  who  would  acquire  a  reputa- 
tion for  dependability  will  not  be  content  with  this 
measure  of  his  duty. 

Is  it  not  true  that  the  stockholder  or  banker  is  being 
taught  to  look  on  the  professional  auditor  as  a  sort  of 
watchdog,  one  who  will  detect  all  irregularities,  insist  on 
businesslike  methods,  see  that  the  accounts  are  stated 
clearly  and  correctly,  and  prevent  unsatisfactory  condi- 
tions generally? 

Now  what  more  important  element  of  business  is  there 


BALANCE    SHEET    AUDIT-ASSETS 


87 


than  "stock-taking"?  Is  it  not  the  most  important  of  all? 
On  it  may  depend  financial  success  or  failure;  on  it  divi- 
dends may  be  paid  or  passed.  Is  it  not  then,  in  every 
sense  of  the  word,  a  financial  transaction  to  be  audited? 

The  English  law  says  that  the  auditor  is  using  reason- 
able care  and  skill  when  he  accepts  the  certificate  of  a 
responsible  ofificial.  The  profession  will  not  advance  in 
usefulness  and  standing  if  this  is  to  be  the  standard  on 
this  side  of  the  Atlantic. 

The  author  differs  from  those  who  maintain  that  an 
auditor,  not  being  a  valuer,  has  no  right  to  attempt  to 
pass  upon  physical  valuations,  including  stock-in-trade 
and  plant;  his  opinion  is  that  an  auditor's  duty  is  not 
properly  performed  unless  he  does  all  that  his  experience 
and  skill  enable  him  to  do. 

Numerous  instances  might  be  cited  where  professional 
auditors,  without  any  special  knowledge  whatever  in 
particular  lines  of  business,  have  detected  overvaluations, 
excessive  statements  of  quantities,  and  misstatements  as 
to  the  condition  of  the  stocks,  some  of  these  discoveries 
being  of  suf^cient  importance  to  stop  the  sale  of  a  business 
or  the  extension  of  a  line  of  credit  by  a  banker. 

In  many  of  these  cases  the  inclusion  in  the  certificate 
by  the  auditor  of  a  statement  to  the  effect  that  he  has 
accepted  -the  inventory  valuations  without  verification 
would. have  been  acceptable  to  his  client  at  the  time,  but 
subsequent  events  would  have  demonstrated  the  worth- 
lessness  of  th^  report  from  a  practical  point  of  view. 

Looking  at  it  from  another  angle,  it  may  be  asked: 
Why  not  as  well  accept  a  certificate  from  the  cashier  that 
the  cash  balance  is  duly  accounted  for,  as  to  accept  the 
certificate  of  the  stockkeeper  that  the  materials  and  goods 
under  his  care  are  on  hand? 

The  author  has  compiled  some  simple  directions  for 


88  AUDITING 

use  by  those  who  desire  to  make  a  real  test  of  what  is 
frequently  the  largest  item  on  a  balance  sheet.  If  these 
are  followed  with  care,  the  auditor  need  have  no  hesitancy 
in  certifying  to  the  accuracy  of  the  inventory  item  in  the 
balance  sheet. 

These  rules  rest  upon  the  assumption  that,  since  an 
auditor  is  not  a  valuer,  he  is  not  charged  with  a  special 
or  technical  knowledge  of  the  elements  surrounding  stock- 
in-trade,  so  that  if  he  exercises  due  care  and  skill  he  may 
feel  that  he  has  conscientiously  discharged  the  duties  im- 
posed upon  him.  They  are  submitted  as  a  guide  to  the 
auditor  who  desires  to  do  all  that  he  can  do  to  inform  his 
clients  as  to  the  exact  conditions  of  the  business  under 
examination. 

Rules  for  Verifying  Inventories 

1.  Secure  original  stock  sheets,  no  matter  how  rough 
or  soiled  they  may  be.  Decline  to  accept  "fair"  copies 
unless  originals  have  been  destroyed,  in  which  case  con- 
sider that  a  prima  facie  case  of  concealment  has  been  made 
out  and  require  strong  affirmative  proof  to  account  for 
the  missing  records. 

2.  If  not  certified  to  or  initialed  by  the  persons  who 
took  the  stock,  by  the  persons  who  made  the  calculations 
and  the  footings,  and  by  those  who  fixed  the  prices,  have 
this  information  supplied  and  see  to  it  that  the  persons 
who  made  the  certificates  or  who  supply  the  information 
are  dependable  and  take  the  matter  seriously.  Insist  on 
a  clear  and  detailed  statement  in  writing  as  to  the  method 
followed  in  taking  and  pricing  the  stock. 

/  3.  Test  the  calculations,  including  all  large  items,  and 
prove  the  footings.  If  the  inventory  is  a  very  extensive 
one  and  made  up  largely  of  small  items,  prove  the  footings 


BALANCE    SHEET    AUDIT— ASSETS  go 

by  sight,  i.e.,  foot  a  page  or  two  and  use  the  totals  of 
those  pages  as  a  mental  guide  in  looking  over  the  other 
pages. 

4.  Where  stock  records  of  prices  and  quantities,  or 
either  one,  are  kept,  compare  the  totals  of  the  physical 
inventory  with  the  book  figures  and  trace  any  material 
discrepancy. 

5.  Where  stock  records  are  kept  and  no  physical  in- 
ventory has  been  taken,  the  former  must  be  very  carefully 
investigated  as  to  the  method  in  use,  the  care  taken  in 
carrying  out  the  system,  and  all  other  features  connected 
therewith  which  will  assist  in  forming  a  conclusion.  As- 
certain when  the  last  physical  inventory  was  taken  and 
compare  same  with  book  records.  If  no  recent  comparison 
is  possible,  select  a  few  book  items  of  importance  and 
personally  compare  with  the  things  themselves.  If  dis- 
crepancies are  found,  do  not  assume,  without  further 
proof,  that  they  are  clerical  errors  only.  Large  thefts  of 
goods  have  been  discovered  by  tests  of  this  kind. 

6.  Ascertain  that  purchase  invoices  for  all  stock  in- 
cluded in  the  inventory  have  been  entered  on  the  books. 
Look  for  post-dated  invoices  and  give  special  attention 
to  goods  in  transit. 

7.  Ascertain  that  nothing  is  included  in  the  inventory 
which  is  not  owned,  but  which  is  on  consignment  from 
others.  If  goods  consigned  to  others  are  included,  see 
that  cost  prices  are  placed  thereon,  less  a  proper  allow- 
ance for  loss,  damage,  or  expenses  of  possible  subsequent 
return.  This  does  not  include  goods  at  branches,  as  the 
valuing  of  such  stocks  will  be  governed  by  the  same  prin- 
ciples as  apply  to  the  head  office.  Ascertain  that  nothing 
is  included  which  has  been  sold,  billed,  and  is  simply  await- 
ing shipment. 

8.  If  duties,  freight,  insurance,  and  other  direct  charges 


90 


AUDITING 


have  been  added,  test  same  to  ascertain  that  no  error  has 
been  made.  Duties  and  freight  are  legitimate  additions  to 
the  cost  price  of  goods,  but  no  other  items  should  be 
added  except  under  unusual  circumstances. 

9.  Select  a  fair  number  of  items  and  compare  the  in- 
ventory prices  with  the  most  recent  purchase  invoices  for 
the  same  kind  of  goods.  If  the  prices  vary,  ascertain  the 
average  cost  of  recent  purchases. 

10.  Make  an  independent  inspection  of  the  inventory 
sheets  to  determine  whether  or  not  the  quantities  are 
reasonable,  and  whether  they  accord  in  particular  instances 
with  the  average  consumption  and  average  purchases 
over  a  fixed  period. 

In  re  Kingston  Cotton  Mill  Company,  an  English  case, 
the  auditor  failed  to  discover  inflation  of  some  years' 
standing  of  both  quantities  and  values  in  the  inventories 
of  cotton  and  yarn  on  hand.  It  appears  to  have  been  ad- 
mitted that  a  comparison  of  the  quantities  of  cotton  pur- 
chased and  of  yarn  sold  with  the  quantities  in  the  inven- 
tories certified  to  the  auditors  by  the  managing  director 
would  have  disclosed  the  fact  that  the  quantities  as  stated 
in  the  inventories  could  not  be  correct,  yet,  despite  this, 
the  court  held  that  the  auditors  were  not  guilty  of  negli- 
gence. The  inventories  were  entered  in  the  balance  sheets 
"as  per  manager's  certificate,"  and  the  court  appears  to 
have  taken  the  view  that  there  was  no  obligation  on  the 
auditors  to  go  back  of  the  manager's  statement.  Most 
prominent  American  accountants  would  now,  however, 
probably  agree  that  such  a  failure  to  discover  the  true 
state  of  affairs  when  the  means  for  doing  so  were  avail- 
able is  inexcusable. 

Remember  that  in  many  classes  of  goods  of  which  full 
stocks  must  be  kept  the  sale  of  a  few  articles  at  a  large 
gross  profit  is  depended  upon  to  offset  the  probable  loss 


BALANCE    SHEET    AUDIT— ASSETS  91 

on  the  goods  unsold  in  the  same  class.  The  residual  stock 
of  such  classes  may  have  little  or  no  value. 

Always  attempt  to  check  the  totals  by  the  "gross 
profit  test"  and  compare  the  percentage  of  gross  profit 
shown  with  that  of  previous  years.  In  a  business  where 
the  average  gross  profit  remains  fairly  constant  this  test 
is  a  dependable  one,  because,  if  the  rate  of  gross  profit  is 
apparently  not  maintained  and  the  discrepancy  cannot  be 
satisfactorily  accounted  ifor  by  a  rise' or  fall  in  the  cost 
of  production  or  of  th^,ii^lling' price,  the  cause  of  diSfer^nce 
will  usually  be  dueito  eVrc^rs  in  stock-talking  or  to  the 
improper  inflatipn  of  values.  ' ,    , 

11.  Compare  the  inventory  sheets  in  a  general  way 
with  those  of  the  previous  period  for  the  purpose  of  noting 
any  variation  in  the  prices  at  which  similar  classes  of  stock 
are  taken.  Classify  both  periods  by  commodities  of  the 
same  class  and  also  by  locality. 

12-.  After  this  is  completed  and  other  parts  of  the  ex- 
amination about  concluded,  apply  the  knowledge  so  ac- 
quired to  answering  the  following  questions: 

(a)  Is  any  of  the  stock  damaged,  depreciated  in  qual- 

ity, or  have  the  styles  or  shapes  changed? 

(b)  Is  any  of  the  stock  obsolete,  out  of  date,  of  a 

siz^  or  quality  no  longer  used?  Have  purchases 
been  made  in  gross  or  dozen  lots  to  secure  a  low 
price,  leaving  many  odds  and  ends  of  broken  lots? 

18.  Scrutinize  sales  since  inventory  date  and  compare 
some  of  the  items  to  determine  whether  there  is  ample 
margin  between  the  two  prices  to  cover  all  expenses  of 
sale  and  handling,  plus  a  profit.  Otherwise  it  may  be 
inferred  that  the  inventory  was  padded,  and  that  just  cause 
exists  for  a  more  comprehensive  examination. 

These  suggestions  may  seem  unduly  extended  and  not 


92  AUDITING 

applicable  to  a  small  business,  or  in  the  case  of  a  quick 
examination  to  ascertain  the  condition  of  the  business. 
Close  study  and  slight  modification  to  meet  particular 
circumstances  will,  however,  prove  their  practicability. 

Goods  in  Process 

If  an  adequate  cost  system  is  in  use,  and  is  accurately 
kept,  it  will  be  found  that  monthly,'  or  more  frequent, 
book  inventories  can  be  consulted.  Comparisons  should 
be  made  of  some  of  the  items  with  actual  physical  in- 
ventories, and  if  any  material  discrepancies  exist,  they 
should  be  investigated. 

Where  a  good  cost  system  is  not  in  force  it  is  almost 
impossible  for  an  auditor  to  verify  the  goods-in-process 
section  of  the  inventory  to  his  satisfaction.  Where  ap- 
plicable, the  rules  cited  above  for  inventories  should  be 
followed,  but  most  of  the  items  will  have  lost  their  iden- 
tity. The  difificulty  of  the  task  must  not  excuse  the 
auditor  from  further  inquiry.  •  He  will  find  in  nearly  every 
case  some  information  bearing  on  the  most  important 
thing  he  wishes  to  know,  viz.,  is  the  inventory  fairly 
priced,  or  is  it  overstated? 

The  financial  standing  and  profits  of  the  undertaking 
must  also  be  taken  into  consideration.  The  concern 
which  realizes  good  profits  is  not  so  apt  to  overstate  its 
inventories  as  the  one  which  is  hard  pressed  for  capital  or 
which  is  unprofitable.  In  the  latter  cases  nearly  every 
one  connected  with  them  may  be  depended  on  to  bolster 
up  a  weak  statement  as  much  as  possible,  and  no  itetn 
in  the  inventory  is  easier  to  juggle  with  than  that  of 
partly  manufactured  merchandise.  The  most  practical 
test  is  an  examination  and  test  of  such  cost  records  as 
may  exist.  No  matter  how  crude  the  accounting  system 
may  be,  no  concern  of  any  size  will  be  without  some  sort 


BALANCE    SHEET    AUDIT— ASSETS  93 

of  cost  records.  It  may  be  difficult  to  get  access  to  them, 
as  many  so-called  practical  superintendents  are  strangely 
non-communicative  as  to  how  they  arrive  at  their  costs. 
They  will  support,  with  much  vigor,  the  contention  that 
modern  cost  systems  are  complicated  and  no  good,  and 
that  they  can  calculate  their  costs  exactly  without  so 
much  detail,  but  they  rarely  consent,  voluntarily,  to  open 
up  their  records.  But  there  must  be  some  one  who  makes 
up  the  costs,  and  the  production  of  these  records  should 
be  insisted  upon.  The  cost  sheets  should  show  the 
successive  steps  of  each  article  manufactured,  and  some  of 
the  stages  may  be  identified  with  the  inventory  items. 

The  auditor  should  probably  leave  this  part  of  the 
audit  until  the  last.  If  the  valuations  of  raw  materials, 
manufactured  goods,  plant  and  machinery,  accounts  re- 
ceivable, etc.,  are  conservative,  he  is  not  called  on  to 
make  an  exhaustive  inquiry  into  goods  in  process.  On 
the  other  hand,  if  other  items  are  overvalued,  the  chances 
are  that  this  item  will  be  even  more  so,  and  he  can  be 
governed  accordingly  in  making  his  recommendations  as 
to  reductions  in  inventory  valuations. 

It  is  urged "*by  some  accountants,  where  goods  are  be- 
ing made  to  order,  or  under  contract,  and  are  therefore 
practically  sold,  that  in  addition  to  direct  costs  and  a 
proportion  of  such  general  expenses  as .  heat,  light  and 
power,  depreciation  and  rent,  there  should  be  added  ad- 
ministration and  selling  expenses.  The  author  does  not 
agree  with  this  view  and  believes  that  in  no  event  will 
conservative  methods  admit  of  any  part  of  administration 
and  selling  expenses  being  added  to  the  cost  of  goods. 

It  seems  hardly  necessary  to  add,  that  in  passing  upon 
the  valuations  of  all  stocks  of  partly  finished  goods  it 
should  be  definitely  ascertained  that  all  of  the  stock  will 
be  completed  within  a  reasonable  time. 


94  AUDITING 

Finished  Goods 

If  a  good  system  of  cost  accounts  is  not  in  force, 
difficulty  will  be  experienced  in  passing  upon  the  prices 
placed  upon  stock-in-trade  which  has  been  manufactured 
or  partly  manufactured.  Where  the  cost  system  is  ac- 
curate and  dependable,  care  must  be  taken  to  ascertain 
that  the  results  shown  thereby  are  used  as  the  basis  for 
the  inventory.  A  practice  which  deserves  condemnation 
is  that  of  pricing  finished  goods  at  sales  prices,  less  an  es- 
timated cost  of  delivery  and  similar  charges.  This,  of 
course,  anticipates  the  entire  profit  on  such  sales,  for  it 
cannot  be  said  that  a  profit  is  ever  earned  until  delivery 
has  been  made  and  a  cause  of  action  established  against 
a  solvent  debtor.  \The  fact  that  goods  may  be  made  up 
on  the  order  of  a  responsible  purchaser  in  no  way  alters 
the  principle.  Until  delivery  has  been  made  and  the 
goods  accepted,  the  sales  contract  is  not  complete.  It  is 
not  uncommon  for  orders  to  be  canceled  or  goods  refused 
for  so  many  reasons  that  they  cannot  be  enumerated  here, 
therefore  no  conservative  manufacturer  considers  that 
any  profit  is  earned  on  undelivered  goods. 

Some  cost  systems  include  ordinary  overhead  charges 
and  others  go  so  far  as  to  include  rent  and  interest.  In 
a  balance  sheet  which  is  to  be  used  as  a  basis  of  credit, 
/  the  item  of  interest  should  not  be  considered  as  a  part 
of  the  cost  of  the  goods  unsold,  and  other  items  nearly 
^  as  questionable,  such  as  rent,  administrative  salaries,  etc., 
should  be  excluded,  unless  the  auditor  is  fully  convinced 
that  their  inclusion  is  in  order.  In  other  words,  do  not 
certify  to  an  "inventory  at  cost"  item  in  the  balance  sheet 
unless  assured  that  ''cost"  in  that  particular  case  carries 
with  it  its  own  explanation,  and  that  subsequent  criticism' 
cannot  arise.  ''Cost"  may  include  all  expenses  incurred 
in  manufacturing,  except  selling  and  managerial  expenses, 


BALANCE    SHEET    AUDIT— ASSETS  gq 

but  no  profit  may  be  included.  The  selling  and  adminis- 
trative expenses  continue  after  the  inventory  date,  and 
profit  should  never  be  anticipated. 

It  is  obvious  that  the  'inventory  at  cost"  item  should 
be  so  certified  only  where  the  cost  price  is  below  the 
net  selling  price,  allowing  for  all  expenses  of  sale  and 
carrying,  and  where  similar  goods  cannot  be  duplicated 
in  the  market  at  a  less  cost.  This  may  be  a  difficult  point 
to  pass  upon,  but  it  must  nevertheless  be  dealt  with.  One 
test  is  the  general  result  of  the  business.  If  conducted 
at  a  loss,  it  might  easily  be  true  that  costs  are  excessive, 
so  that  to  use  such  figures  would  be  to  overvalue  the 
assets  to  that  extent.  If  a  factory  is  running  on  part 
time  only  or  if  it  is  a  new  enterprise,  the  actual  cost  of 
production  may  be  in  excess  of  the  market  value  of  similar 
goods.  In  such  cases  the  stock  should  be  marked  down 
to  the  market  price. 

In  other  respects  the  procedure  in  verifying  the  in- 
ventory of  finished  goods  is  the  same  as  that  suggested 
for  "raw  matqfials."     (See  pages  84-88.) 

Interest  Not  an  Element  of  Cost 

The  question  as  to  whether  or  not  interest  on  capital 
invested  in  plant  is  a  proper  item  to  be  considered  in  de- 
termining the  manufacturing  cost  of  goods,  has  been 
fully  debated  by  accountants  and  economists.  Those  in- 
terested in  the  arguments  used  on  both  sides  of  the 
question  should  consult  the  volumes  of  the  Journal  of 
Accountancy.  The  author  takes  the  definite  position  that 
it  is  fallacious  to  treat  it  as  an  element  of  cost. 

Apart  from  other  and  good  reasons,  the  fundamental 
difficulties  involved  in  the  attempt  to  standardize  the  in- 
terest charge  are  so  great  as  to  prove  the  weakness  of 
the  argument.    Interest  rates  and  the  equivalent,  i.e.,  the 


96 


AUDITING 


actual  cost  of  invested  capital,  vary  to  a  marked  degree. 
For  example,  if  the  capital  of  one  concern  is  secured  by 
the  sale  of  common  stock  at  par,  and  by  another  from 
the  proceeds  of  sale  of  an  8  per  cent  preferred  stock  at  90, 
redeemable  at  125,  what  interest  rates,  respectively,  should 
be  used?  These  examples  are  not  extremes;  they  are 
fairly  typical  of  corporate  financing. 

A  fixed,  or  arbitary,  rate  cannot  be  used,  as  it  is 
neither  fish  nor  fowl.  The  proponents  are  sadly  at  sea 
as  to  details.  Is  interest  (if  the  rate  be  found)  to  be  cal- 
culated on  the  cost  or  value  of  land,  buildings,  and  equip- 
ment; on  tools  and  fixtures;  on  raw  materials  and  goods 
in  process;  or,  as  has  been  suggested  facetiously,  on  wages 
from  time  of  payment  to  time  of  completion? 

If  charged  into  costs,  what  corresponding  credit  is 
to  be  made?  If  to  profit  and  loss,  it  might  easily  result 
in  a  new  concern  showing  a  handsome  profit  from  manu- 
facturing before  a  dollar's  worth  of  goods  were  sold. 

Important  reasons  for  determining  the  cost  of  goods 
are  for  inventory  purposes  and  to  establish  sales  prices. 
In  the  former  case  the  inclusion  of  interest  results  in  an 
actual  padding  of  the  inventory  and  if  approved  by  an 
auditor  would  justly  subject  him  to  the  criticism  of 
bankers.  In  the  latter  case  no  substantial  benefit  is  se- 
cured. Intelligent  manufacturers,  in  fixing  the  selling 
prices  of  goods,  if  not  wholly  governed  by  the  prices  es- 
tablished by  competition,  give  due  consideration  to  all 
costs  other  than  manufacturing,  such  as  administrative 
and  sales  expenses.  They  can  be  depended  upon  to  con- 
sider the  possible  return  upon  invested  capital,  either  as 
a  specific  rate  they  desire  to  earn  or  as  "all  the  traffic 
will  bear." 

All  costs,  properly  calculated,  include  a  provision  for 
the  up-keep  and  renewal  of  the  plant.    Anything  beyond 


BALANCE    SHEET    AUDIT— ASSETS  07 

this  must  be  an  earning  or  profit  arising  out  of  the  use 
of  the  plant.  It  is  quite  true  that  modern  conditions 
seem  to  force  a  constant  increase  in  plant  investment, 
frequently  out  of  proportion  to  increased  output.  This 
tendency,  however,  cannot  be  overlooked,  as  is  feared  by 
some,  because  there  is  a  corresponding  increase  in  depre- 
ciation charges,  in  addition  to  the  ever  present  item  of 
increased  capital  investment  upon  which  a  remunerative 
return  is  expected. 

It  is  not  a  good  argument  that  a  manufacturer  must 
be  urged  to  include  interest  as  a  factor  of  operating  cost, 
because  otherwise  he  will  not  realize  that  goods  produced 
by  the  use  of  expensive  machinery  may  actually  cost  as 
much,  or  more,  as  goods  produced  by  hand  labor.  It  is 
inconceivable  that  a  manufacturer  who  must  constantly 
weigh  the  advantages  and  disadvantages  of  various 
methods  of  production,  will  remain  ignorant  of  the  fact 
that  machinery  costs  money,  must  be  maintained  and  re- 
newed, and  that  the  sales  price  of  his  product  must  if 
possible  include  an  adequate  return  upon  the  capital  in- 
vestment. 

It  is  unsound  argument  to  say  that  interest  on  the 
investment  must  be  met.  Unfortunately  manufacturers 
do  not  always  realize  sufificient  profit  to  equal  a  fair  rate 
on  their  investment.  It  is  absurd  to  charge,  say,  6  per 
cent  interest  on  capital  as  an  element  of  manufacturing 
cost,  and  then  in  the  profit  and  loss  account  show  a  loss 
equal  to  3  per  cent.  Such  books  are  erroneous.  Actually 
the  plant  has  earned  3  per  cent  net  on  the  investment;  it 
has  not  earned  part  and  lost  part.  It  is  synonymous  with 
partners'  salaries.  A  partner  acting  as  superintendent  of 
a  factory,  who  includes  a  weekly  allowance  of  $100  to 
himself  in  the  pay-roll  and  charges  it  as  a  factor  of  manu- 
facturing cost,  deceives  himself  if  he  thinks  the  factory 


98  AUDITING 

mtist  stand  it.  If  the  final  result  for  the  year  shows  his 
share  of  the  profits  to  be  $2,600,  after  treating  the 
''salary"  as  an  expense,  mere  bookkeeping  entries  cannot 
obscure  the  actual  result,  i.e.,  that  he  has  reaUzed  $7,800 
for  the  year. 

For  an  interesting  legal  decision  supporting  the  con- 
tention that  interest  on  capital  invested  in  a  business 
is  not  an  element  of  cost,  see  Journal  of  Accountancy, 
Vol.  XVI,  page  145,  and  other  cases  cited  therein. 

The  Turnover 

While  the  inventory  is  being  verified,  the  auditor 
should  ascertain  the  aggregate  sales  for  the  last  year.  If 
the  turnover  has  not  been  rapid,  it  may  be  due  to  a  poor 
stock  of  goods.  Some  business  men  dislike  to  sell  below- 
cost  and  would  rather  accumulate  a  big  stock  of  old 
goods  than  dispose  of  the  old  and  unseasonable  stock  at 
a  sacrifice.  The  usual  outcome  is  that  the  stock  becomes 
unwieldy  and  funds  are  lacking  to  purchase  new  goods. 
The  inventory  and  the  gross  sales  may,  therefore,  have 
a  direct  connection. 

An  auditor  should  always  seize  an  opportunity  to  com- 
pile data  with  respect  to  the  number  of  times  various 
stocks  of  goods  are  or  should  be  turned  over  in  a  year. 

Supplies,  Stores,  etc. 

In  addition  to  the  regular  stock-in-trade,  other  sup- 
plies are  usually  on  hand  and  should,  of  course,  appear  in 
the  inventory,  unless  the  total  value  is  very  small. 

These  items  should  be  separated  from  the  merchandise 
stock,  as  one  class  represents  an  asset  which  it  is  expected 
will  be  converted  directly  into  the  equivalent  of  cash; 
whereas  such  items  as  fuel,  office  and  factory  supplies,  re- 
pair parts,  and  similar  materials  and  stores,  represent  ex- 


BALANCE    SHEET    AUDIT— ASSETS 


99 


penditures  about  to  be  made  for  maintenance,  and  there- 
fore not  to  be.  included  in  a  calculation  as  to  how  much 
can  be  realized  within  a  given  time  to  pay  debts. 

The  general  rule  of  valuation  also  applies,  i.e.,  cost  or 
market,  whichever  is  the  lower.  Care  must  be  taken  that 
nothing  is  included  except  usable  items.  The  auditor 
should  demand  the  original  stock  sheets  and  test  thetr 
accuracy  sufficiently  to  satisfy  himself  that  the  item  is  a 
genuine  one,  and  that  quantities  are  not  overstated. 

It  is  sometimes  found  that  articles  partly  used  are  in- 
cluded under  this  caption,  but  it  is  not  proper  to  include 
anything  except  new  and  usable  materials,  which  would 
have  to  be  duplicated  at  the  same  or  a  greater  cost  if  they 
were  not  on  hand. 

Investment  Securities 

As  we  are  now  discussing  current  or  quick  assets,  it 
must  be  understood  that  the  term  "investment  securities" 
does  not  include  any  securities  the  sale  of  which  would 
afiPect  the  normal  operation  of  a  business. 

Where  stocks  or  bonds  represent  control  or  a  material 
interest  in  other  enterprises,  the  ownership  of  which  car- 
ries more  or  less  value  to  the  holder  outside  of  the  direct 
return  thereon,  they  should  be  designated  as  fixed  and 
not  current  assets. 

Securities  as  Stock-in-Trade 

Where  the  purchase  and  sale  of  securities  is  part  of 
the  regular  business  of  the  firm  or  corporation,  an  in- 
ventory thereof  should  be  taken  as  with  the  stock-in- 
trade  of  other  concerns. 

It  is  usually  easier  to  ascertain  market  values  than  is 
the  case  with  other  inventories,  but  greater  care  must 
be  taken  with  the  individual  items.     The  rule  of  cost  or 


lOO  AUDITING 

market,  whichever  is  the  lower,  also  applies  and  governs 
each  item  rather  than  the  aggregate.  That  is,  any  se- 
curity which  has  depreciated  in  value  should  be  written 
down  to  the  market,  but  an  apparent  rise  in  value  should 
not  be  taken  advantage  of  unless  the  securities  are  in 
active  demand  and  the  market  continues  in  an  equally 
satisfactory  condition  after  the  date  of  the  balance  sheet 
and  up  to  the  time  of  the  report. 

It  frequently  happens  that  a  few  sales  of  an  inactive 
security  may  appear  to  fix  a  higher  valuation  than  that 
at  which  they  are  carried,  but  these  sales  and  quotations 
are  exceedingly  -uncertain.  The  auditor,  in  pricing  se- 
curities, must  be  sure  of  his  evidence. 

The  securities  must  be  examined  by  the  auditor  in 
person  or  he  must  secure  confirmations  of  their  existence 
from  those  who  hold  them.  It  is  needless  to  say  that  the 
securities  should  be  counted  as  soon  as  possible  after  the 
audit  starts,  and  that  all  should  be  submitted  to  the 
auditor  at  one  time.  If  this  is  not  practicable,  the  auditor 
should  place  one  of  his  assistants  in  a  position  where  all 
changes  between  the  commencement  of  the  audit  and 
the  completion  of  the  verification  of  the  securities  can 
be  noted. 

Certificates  out  for  transfer  should  be  verified  by  cor- 
respondence. 

As  coupons  due  at  future  dates  may  be  detached  and 
sold,  the  careful  auditor  will  note  that  bonds  have  all  un- 
matured coupons  attached.  Where  investments  are  sup- 
posed to  remain  unchanged,  it  is  suggested  that  the 
auditor  note  the  serial  numbers  of  a  few  representative 
stocks  and  bonds  and  check  these  numbers  on  subsequent 
visits.  Instances  have  been  known  where  securities  have 
been  sold  immediately  after  an  audit  and  replaced  before 
the  commencement  of  another. 


BALANCE    SHEET    AUDIT— ASSETS  jqi 

A  director  of  a  bank  told  the  author  that  in  examining 
securities  the  same  lot  of  bonds  had  been  handed  to  him 
four  or  five  times  at  each  examination  during  a  period  of 
some  years.  If  ordinary  precautions  had  been  taken  and 
all  the  securities  ordered  into  the  directors'  room  at  one 
time — a  feasible  and  simple  plan  in  this  instance — a  large 
defalcation  would  have  been  prevented  or  discovered  at 
an  early  stage. 

Temporary  Investments 

Considerable  publicity  has  been  given  in  recent  years 
to  the  desirability  of  trading  and  manufacturing  concerns 
purchasing  and  carrying  a  reasonable  line  of  market- 
able securities  to  provide  for  unforeseen  contingencies,  or 
for  extensions  of  the  business  or  other  extraordinary 
needs  which  require  funds  on  short  notice. 

The  theory  is  that  many  businesses  which  have  ex- 
panded rapidly,  and  which  are  apparently  prosperous, 
have  invested  all  of  their  available  capital  and  surplus  in 
extensions  of  their  plant,  etc.,  and  a  sudden  call  for  cash 
finds  them  in  a  vulnerable  position.  This  argument  is 
sound  enough  from  a  conservative  point  of  view,  but  it 
may  be  urged  that  the  merchant  who  is  too  conservative 
will  never  buy,  for  fear  he  cannot  sell,  and  that  he  may 
as  well  invest  his  surplus  earnings  in  his  own  business 
and  thus  earn  a  much  higher  return  than  is  realized  from 
securities. 

This  is  peculiarly  a  question  to  be  decided  on  its 
merits  in  each  case,  but  it  may  be  remarked  in  passing 
that  the  principal  exponents  of  this  plan  for  business  men 
are  periodicals,  the  success  of  whose  financial  advice  de- 
partments depends  on  the  advertising  patronage  they  re- 
ceive from  bond  houses. 

These  investment  securities,   to  fulfil   their  function 


I02  AUDITING 

properly,  should  be  on  hand  (not  hypothecated)  and  be 
presented  to  the  auditor  for  his  inspection. 

As  the  whole  theory  of  these  security  holdings  lies  in 
their  availability,  they  should  be  priced  at  their  fair  market 
valuation  as  on  the  balance  sheet  date,  irrespective  of 
cost.  Otherwise,  they  cannot  be  considered  as  the 
equivalent  of  cash.  This,  however,  is  not  a  hard-and-fast 
rule.  Where  the  variations  in  market  prices  are  slight 
and  the  tendency  is  upward,  no  adjustment  in  values 
need  be  made.  Where  the  tendency  is  downward  the 
auditor  should  insist  on  a  revaluation  unless  the  variation 
is  so  small  that  the  difference  is  trifling. 

A  further  test  of  the  availability  of  this  class  of  se- 
curities is  the  existence  of  a  firm  market  and  stable  quota- 
tions. If  not  listed  on  the  stock  exchange  the  bankers 
who  make  a  specialty  of  the  particular  issues  should  be 
asked  for  a  ''bid-and-asked"  quotation  as  of  the  date  of 
the  balance  sheet. 

Postage  and  Other  Stamps 

In  most  audits  this  item  will  be  unimportant,  but  in 
some  classes  of  business  the  stamps  on  hand  will  be 
sufficiently  large  to  require  attention.  This  is  particu- 
larly the  case  with  stock-brokers  in  New  York,  who 
usually  carry  large  quantities  of  transfer  stamps. 

The  principal  reason  for  presenting  the  matter  at  this 
point  is  that  it  gives  an  auditor  an  opportunity  to  inquire 
about  the  stock  of  stamps  on  hand  and  to  look  into  the 
method  of  handling  them.  So  much  carelessness  exists  in 
this  matter  that  it  is  well  worth  investigating. 

Deferred  Charges  to  Operation 

In  nearly  all  balance  sheets  items  will  appear  which 
can  be  classified  under  this  caption,  although  in  many 


BALANCE    SHEET    AUDIT— ASSETS  103 

cases  where  there  are  only  one  or  two  accounts  such  as 
prepaid  insurance,  rents,  etc.,  there  is  no  grouping,  but 
the  items  are  stated  in  detail. 

The  auditor  cannot  verify  the  accuracy  of  the  book 
figures  unless  an  analysis  is  made  of  the  charges  to  the 
various  accounts.  As  this  subject  is  discussed  fully  in 
the  chapter  on  the  detailed  audit  (Chapter  XIV),  no  com- 
ment is  here  required. 


CHAPTER    VI 

BALANCE    SHEET    AUDIT— ASSETS     (Continued) 


FIXED'  ASSETS 

As  distinguished  from  current  asse4:s,  those  more  or 
less  permanent  with  which  the  business  is  carried  on  are 
generally  known  as  fixed  assets.  Instead  of  being  offered 
for  sale  they  are  maintained,  or  renewed,  and  their  use 
provides  the  means  of  carrying  on  the  business. 

Period  to  be  Covered 

Where  an  audit  covers  several  years,  or  the  entire  life 
of  the  undertaking,  an  analysis  of  the  items  of  fixed  plant 
will  be-  made  in  due  course  and  the  auditor  will  have  be- 
fore him  all  of  the  facts  upon  which  to  base  an  opinion 
as  to  whether  or  not  the  accounts  represent  fair  cost  of 
the  existing  assets.  In  a  balance  sheet  audit,  however,  the 
period  to  be  covered  usually  rests  with  the  auditor,  and 
a  serious  question  arises  as  to  how  far  the  book  vaKiations 
may  be  accepted  as  a  basis  for  actual  values,  assuming 
that  the  concern  is  to  be  valued  as  a  going  business,  and 
that  cost,  less  proper  depreciation,  is  the  result  desired. 

The  auditor  may  as  well  accept  the  position  here,  as 
with  inventories,  that  he  is  expected  to  report  the  facts 
about  the  plant  account;  where  he  cannot  secure  reliable 
information  with  respect  to  plant  vakies  he  should  state 
in   his   report    that    real   estate,    machinery,    and    similar 

104 


BALANCE    SHEET    AUDIT— ASSETS 


105 


assets  are  stated  at  book  valuations.  He  should,  however, 
attempt  to  ascertain  whether  these  book  valuations  hon- 
estly reflect  present  conditions.  His  services  are  of  little 
real  value  if  such  items  are  grossly  overvalued  and  a  net 
worth  is  shown  which  should  be  corrected  by  an  intelli- 
gent use  of  evidence  easily  available  by  the  auditor. 

The  auditor  is  charged  with  the  duty  of  attempting  to 
analyze  the  items  of  fixed  assets  as  shown  by  the  books  to 
ascertain  the  principles  upon  which  they  have  been  created. 
In  a  few  large  enterprises  an  item  of  "plant"  will  appear 
which  represents  an  aggregate  valuation  covering  the 
purchase  price  of  perhaps  the  entire  fixed  property.  It 
may  be  largely  overvalued  to  offset  common  capital  stock 
issued  in  payment  therefor.  In  such  cases,  and  in  the 
absence  of  an  appraisal  of  actual  physical  values,  the 
problem  is  difficult  and  requires  more  detailed  attention 
than  can  be  devoted  to.  it  in  a  general  treatise  of  this 
nature.  The  auditor,  of  course,  cannot  intelligently 
criticize  such  a  valuation,  even  if  it  is  absurdly  excessive, 
unless  he  can  secure  an  appraisal,  approximate  or  actual. 
A  statement  that  the  plant  is  obviously  greatly  over- 
valued might  lead  bankers  or  others  interested  to  call 
for  an  appraisement. 

Auditors  whose  practice  is  chiefly  with  large  corpora- 
tions meet  this  problem  frequently.  Mergers  and  re- 
organizations lead  to  ''lump"  sums  among  fixed  assets  and 
any  analysis  thereof  is  out  of  the  question.  The  records 
are  not,  as  a  rule,  available,  and  if  they  were  there  would 
be  so  many  changes  in  the  principal  items  that  the 
auditor  would  not  be  much  better  off.  The  property  of 
large  corporations  is  apt  to  depreciate  or  appreciate  to 
a  considerable  extent;  it  rarely  stands  still.  In  the  case 
of  railroads  the  Interstate  Commerce  Commission  desired 
an  analysis  of  the  property  accounts  of  all  roads  reporting 


Io6  AUDITING 

to  it,  but  frankly  gave  up  the  problem  and  finally  settled 
on  the  requirement  that  all  additions  subsequent  to  July  1, 
1907,  be  analyzed  in  detail. 

This  course  may  be  followed  to  advantage  in  industrial 
corporations.  The  lack  of  past  data  is  no  excuse  for  a 
continuance  of  poor  bookkeeping,  and  the  auditor  who 
has  any  influence  in  the  matter  should  request  that  in- 
telligent analyses  of  all  capital  expenditures  be  preserved. 

In  many  corporations  the  property  accounts  represent 
menely  the  securities  issued  and  their  actual  value  is  not 
of  prime  importance  to  the  auditor.  He  is  greatly  in- 
terested, however,  in  the  operation  and  development  of 
the  enterprises  and  must  assume  the  responsibility  of 
classifying  subsequent  expenditure  between  capital  and 
income. 

In  a  great  many  balance  sheet  audits  data  can  be  se- 
cured without  much  trouble  which  will  show  the  com- 
ponent elements  of  the  values,  viz.,  the  book  cost  of  the 
various  divisions  of  the  plant  and  equipment  accounts, 
whether  the  charges  appear  to  include  only  items  of 
additions  and  betterments,  and  if  depreciation  has  been 
provided  for. 

In  brief,  in  all  balance  sheet  audits  the  auditor  must, 
if  possible,  secure  an  analysis  of  the  existing  book  valua- 
tions, even  if  it  is  necessary  to  go  back  over  the  trans- 
actions of  many  years. 

The  absence  of  plant  ledgers  with  explanatory  details, 
is  an  omission  which  should  be  commented  upon  un- 
favorably. 

The  borrowers  whose  books  do  not  lend  themselves 
readily  to  an  audit  by  professional  accountants  are  usually 
the  ones  whose  financial  statements  need  serious  scrutiny 
on  the  part  of  prospective  lenders  and  creditors. 

The  United  States  Bureau  of  Corporations  takes  the 


BALANCE    SHEET    AUDIT— ASSETS  107 

position  that  plant  or  property  accounts  ought  not  to  be 
made  to  include  any  intangible  values,  or  to  conceal  any 
deficiencies  in  tangible  assets  as  compared  with  capital 
stock  or  liabilities.  Obviously  this  position  meets  with 
the  approval  of  professional  auditors. 

Value  as  a  Going  Concern 

We  are  dealing  with  enterprises  which  are  continuing 
in  business,  and  of  which  a  forced  sale  or  liquidation  is 
not  contemplated,  so  that  in  attempting  to  fix  the  net 
value  to  a  concern  of  its  fixed  assets  we  may  say  that,  as 
a  general  rule,  the  correct  basis  is  cost,  less  adequate  de- 
preciation for  wear  and  tear  and  obsolescence. 

It  need  not  be  considered  that  the  dismantling  of  a 
plant  or  a  forced  sale  under  unfavorable  circumstances 
would  seriously  disarrange  the  book  values,  provided  the 
latter  were  based  on  the  foregoing  rule.  This  aspect  of 
the  case  is  well  known  to  all  who  are  interested,  but  no 
one,  not  even  a  banker,  would  contend  that  the  balance 
sheet  of  a  live  enterprise  should  exhibit  its  assets  at  a 
"scrap"  valuation. 

Land  and  Buildings 

Many  auditors  are  too  apt  to  take  it  for  granted  that 
real  estate,  a  record  of  which  appears  in  the  books  of 
account  as  owned,  is  actually  the  property  of  the  busi- 
ness under  audit,  and  that  it  is  free  and  clear  unless  a 
mortgage  also  appears  on  the  books.  As  a  matter  of  fact, 
serious  flaws  have  developed  in  the  title  to  real  estate 
which  has  been  carried  on  balance  sheets  as  an  asset  and 
which  has  been  relied  upon  as  a  basis  for  credit. 

This  is  not  a  difficult  matter  to  cover,  much  easier,  in 
fact,  than  many  of  the  other  items  on  the  balance  sheet 
of  considerably  smaller  amount.     The  most  practicable 


I08  AUDITING 

method,  and  one  on  which  an  auditor  is  entitled  to  rely, 
is  to  secure  from  the  regular  attorney  or  a  title  company 
a  letter  or  certificate,  properly  signed,  stating: 

1.  Whether  the  title  to  the  real  estate  as  it  appears, 
or  is  described,  on  the  books  is  in  the  name  of  the  in- 
dividual, firm,  or  corporation  whose  name  appears  at  the 
top  of  the  balance  sheet  or  in  the  auditor's  certificate. 

2.  That  the  said  real  estate  is  free  and  clear  of  any 
liens  whatever,  including  the  following: 

(a)  Mortgages 

(b)  Judgments 

(c)  Taxes,  water  rent,  and  other  municipal  liens 

While  the  foregoing  liens,  if  disclosed,  would  appear 
among  the  liabilities,  yet  the  place  in  an  audit  to  cover 
this  point  is  in  connection  with  the  verification  of  the 
asset  side  of  the  balance  sheet. 

It  may  be  urged  that  an  auditor  should  not  depend 
upon  the  certificate  of  an  attorney  when  there  is  no 
special  difficulty  in  having  a-search  of  the  public  records 
made  by  his  own  staff,  or  by  some  one  not  connected  with 
the  enterprise,  but  in  practically  all  cases  the  result 
would  not  be  any  more  satisfactory,  and  in  most  cases 
difficulties  present  themselves  which  make  it  inadvisable 
for  the  auditor  to  attempt  to  assume  the  work  of  a  lawyer. 

An  important  distinction  which  must  not  be  lost  sight 
of  is  the  classification  of  the  real  estate.  A  balance  sheet 
should  always  show: 

1.  Real  estate  used  in  the  business 

2.  Other  real  estate  (if  any) 

This  segregation  applies  to  all  concerns  except  those  in 
which  real  estate  is  dealt  in  as  a  commodity.  Taken  in 
connection  with  the  profit  and  loss  account  it  shows  at  a 
glance  whether  the  outside  real  estate  is  producing  enough 


BALANCE    SHEET    AUDIT— ASSETS  109 

revenue  to  warrant  holding  it,  and  taken  into  considera- 
tion with  respect  to  the  indebtedness,  it  will  afiford  an 
opportunity  to  decide  whether  it  is  wise  to  hold  it  in- 
definitely. 

I.  Land 

Land  should  appear  in  the  balance  sheet  at  cost,  and 
should  not  be  written  up,  although  it  may  be  clearly 
established  that  values  have  increased.  As  a  matter  of 
fact,  an  increment  in  the  value  of  land  usually  means 
higher  taxes,  with  no  increase  in  earning  power,  so  that 
the  increased  valuation  is  a  detriment  so  far  as  current 
operations  are  concerned.  The  business  does  not  receive 
any  benefit  therefrom  except  in  case  of.  a  sale  or  a  liquida- 
tion, and  an  adjustment  of  the  book  value  need  not  be 
considered  till  these  actually  occur. 

Similarly,  if  the  land  has  apparently  depreciated  in 
value,  custom  justifies  the  carrying  of  this  item  at  cost 
until  realization,  at  which  time  only  can  the  actual  value 
be  determined. 

A  distinction  must  be  made  between  improved  and 
unimproved  property.  With  the  latter  taxes  and  other 
carrying  charges  are  sometimes  added  to  the  cost.  The 
auditor  should  make  a  careful  analysis  of  the  items  for 
use  in  his  report.  The  facts  speak  for  themselves  so 
strongly  that  the  auditor  need  do  no  more  than  refer  to 
the  items.  All  carrying  charges  including  interest,  should 
be  treated  as  revenue  expenditures  unless  it  is  obvious 
that  there  is  a  continuous  increase  in  the  actual  value  of 
the  property.  When  this  is  affirmatively  shown,  the  carry- 
ing charges  may  be  capitalized. 

The  largest  realty  company  in  the  United  States  ob- 
serves the  following  rule,  as  stated  in  its  last  annual  re-, 
port: 


no  AUDITING 

The  company's  real  estate  is  carried  on  its  books  at  its  original 
cost.  The  entire  expense  of  carrying  the  unproductive  real  estate  is 
charged  out  of  income,  but  in  order  to  show  the  amount  which  the 
respective  properties  have  actually  cost  us,  this  expense  has  been 
added  to  book  value  and  a  like  amount  has  been  set  aside  as  a  reserve. 


This  is  conservative  practice  and  is  to  be  commended. 

Where  the  auditor  finds  that  an  adjustment  has  been 
made  increasing  the  book  value  of  land,  the  fact  should 
be  noted  on  the  balance  sheet.  Otherwise,  a  situation 
like  the  following  may  arise: 

A  corporation  had  accumulated  an  operating  loss  of 
about  two  hundred  thousand  dollars.  Its  land  was 
within  the  limits  of  a  large  city  and  had  obviously 
increased  greatly  in  value,  but  no  adjustment  of  the  same 
had  been  made  in  the  books.  The  company  was  at  times 
a  borrower  up  to  about  a  million  dollars,  and  the  banks 
required  periodical  financial  statements.  The  banks  did 
not,  however,  require,  and  the  corporation  did  not  fur- 
nish, the  certified  statements  furnished  by  the  auditors 
(which  exhibited  the  land  at  cost  and  the  deficit  men- 
tioned above),  but  did  furnish  a  balance  sheet  in  which 
the  land  value  was  marked  up  several  hundred  thousand 
dollars — enough  to  wipe  out  the  deficit  and  produce  a 
surplus.  As  the  land  valuations  were  not  excessive,  the 
banks  were  not  put  upon  notice  that  the  company  was 
losing  money  and  that  the  books  showed  a  defkit. 

Property  may  be  situated  in  or  near  a  city  and  as 
time  goes  on  may  appreciate  greatly  in  value  based  on 
transfers  or  appraisements  of  land  similarly  located.  It 
must  be  remembered,  however,  that  it  is  a  fallacy  to 
assume  that  the  value  of  land  available  for  any  kind  of 
improvement  can  be  directly  compared  with  the  value  of 
land  upon  which  a  manufacturing  plant  has  been  erected. 
The  value  of  the  plant  cannot  be  separated  from  the  value 


BALANCE    SHEET    AUDIT— ASSETS  m 

of  the  land  itself,  because,  based  upon  the  assumption 
that  the  land  could  be  sold  for  general  purposes,  in 
ninety-nine  cases  out  of  one  hundred  the  buildings 
(being  adapted  for  one  purpose  only)  would  have  to 
be  demoHshed  and  the  capital  loss  thus  sustained  would 
more  than  offset  the  appreciation  in  the  value  of  the 
land. 

Therefore  an  apparent  rise  in  the  value  of  the  land  is 
not  the  equivalent  of  an  increase  in  assets  unless  the 
proportion  the  improvements  bear  to  the  entire  invest- 
ment is  a  small  one.  The  auditor  can  readily  test  the  pro- 
priety of  such  a  statement  of  increased  land  value  by 
asking  the  question:  Is  the  land  available  for  sale  aside 
from  the  improvements? 

Bankers  are  strangely  negligent  in  accepting  such 
statements,  when  they  could  without  cost  just  as  well 
have  the  facts.  No  borrower  could  afford  to  refuse  to 
furnish  a  certified  statement  when  called  upon  to  do  so 
by  the  lender. 

2.  Buildings 

The  valuation  of  buildings  opens  up  the  question  of 
depreciation,  which  is  discussed  fully  in  Chapter  XVIIT. 
Following  the  suggestions  there  made,  buildings  should 
appear  on  the  balance  sheet  at  cost  and  a  reserve  should 
be  created  sufficient  to  cover  the  wear  and  tear  and  obso- 
lescence thereof,  accrued  to  the  date  of  the  balance  sheet. 

As  an  aid  to  forming  an  opinion  upon  the  value  of 
buildings,  the  auditor  should  personally  inspect  the  plant 
and  note  whether  it  appears  to  be  in  good  condition. 

Leaseholds 

Very  few  manufacturing  plants  in  the  United  States 
are  built  on  leased  premises,  but  inquiry  as  to  this  should 


112  AUDITING 

be  made,  however,  in  every  audit  where  real  estate  appears 
as  an  asset.  In  a  surprisingly  large  number  of  cases 
hotels,  theaters,  office  and  "loft"  skyscrapers,  and  other 
business  buildings  are  erected  on  land  which  is  leased  for 
a  definite  term  of  years. 

So  far  as  the  author  has  been  able  to  discover,  it  is 
not  customary  for  the  owners  of  such  buildings  to  pro- 
vide a  sinking  fund  to  take  care  of  the  diminishing  value 
of  their  property,  nor  even  to  charge  depreciation  as  one 
of  their  expenses.  There  are  two  reasons  for  this:  first, 
the  term  is  usually  a  long  one,  running  from  twenty-one 
to  ninety-nine  years.  In  this  age  of  startling  changes 
such  a  long  term,  or  one  of  sixty-three  or  eighty-four 
years — the  latter  being  the  most  popular  in  New  York 
City — is  equivalent  in  the  minds  of  real  estate  operators, 
to  a  freehold,  and  no  provision  for  the  far  distant  future 
seems  necessary.  The  second  reason  is  that  in  the  great 
majority  of  cases  land  has  appreciated  in  value  faster  than 
the  buildings  thereon  have  depreciated.  For  instance,  a 
building  on  upper  Fifth  Avenue,  New  York,  built  twenty 
years  ago  on  leased  ground,  with,  say  forty-three  years 
to  run  before  the  lease  expires,  could  be  demolished  and 
the  vacant  land  sublet  for  a  great  deal  more  than  the 
building  was  worth,  in  addition  to  the  rental  under  the 
original  lease.  With  similar  experiences  in  other  cities  it 
is  difficult  to  persuade  the  builder  that  a  sinking  fund 
should  be  created,  although  he  will  probably  admit  that 
the  building  is  depreciating  in  value. 

The  auditor  should  use  this  admission  as  a  basis  for  the 
argument  that  the  depreciation  in  value  of  a  building, 
computed  on  its  life  and  on  the  expiration  of  the  lease,  is 
an  annual  charge  against  the  revenue  which  the  building 
produces;  that,  unless  and  until  the  leasehold  is  sold  or 
parted  with,  the  only  facts  at  hand  are  that  the  building 


BALANCE    SHEET    AUDIT— ASSETS  113 

is  diminishing  in  value,  slowly  but  surely,  from  the  two 
causes  stated. 

An  auditor  should  not  set  off  one  against  the  other 
without  so  stating  the  fact  in  his  certificate  or  showing 
it  on  the  balance  sheet,  otherwise  he  is  guilty  of  conniv- 
ing at  a  practice  shunned  by  all  conservative  men,  viz., 
taking  credit  in  a  current  period  for  a  prospective  profit. 
Nevertheless,  he  must  not  ignore  the  question  of  a  rise 
in  value,  as  it  may  have  an  important  bearing  on  the 
borrowing  capacity  of  the  concern.  Therefore,  whenever 
an  auditor  is  met  with  a  claim  that  the  unexpired  portion 
of  a  leasehold  is  of  great  value,  he  should  secure  an 
appraisal  thereof  from  a  reliable  and  disinterested  real 
estate  agent. 

If  a  lease  has  been  purchased,  and  the  purchase  price 
appears  on  the  books  as  an  asset,  the  expired  portion 
should  be  written  off  periodically.  If  an  appraisal  should 
establish  the  fact  that  the  price  paid  was  too  high,  it 
would  be  wise  and  conservative  to  increase  the  instal- 
ments to  such  an  extent  that  the  cost  would  be  written 
off  before  the  expiration  of  the  lease.  But  if  this  is  not 
satisfactory  to  the  lessee,  the  auditor  would  not  be  justi- 
fied in  insisting  upon  it  any  more  than  he  would  be  in 
requiring  a  tenant  who,  under  a  long  lease,  is  paying 
more  rent  than  similar  space  could  be  secured  for  later, 
to  set  up  a  reserve  for  excessive  rent. 

Machinery  and  Equipment 

As  with  buildings,  machinery  should  be  valued  at 
cost  and  a  sufficient  reserve  provided  to  cover  deprecia- 
tion. In  determining  the  sufficiency  of  the  machinery 
reserve,  consideration  should  be  given  to  the  question 
of  obsolescence.  No  general  rule  can  be  found  which  will 
govern  the  rates  of  depreciation  applicable  to  any  par- 


114 


AUDITING 


ticular  plant.  Much  depends  upon  the  way  the  machinery 
is  used  and  cared  for.  The  life  of  a  lathe  in  one  plant 
may  be  twenty  years;  in  another  the  same  lathe  will  be 
out  of  commission  in  ten  years. 

The  auditor  must  apply  the  general,  principles  of 
depreciation  to  the  item  of  machinery  and  then  bring 
to  bear  the  special  knowledge  he  has  gained  of  the  plant 
under  review  before  expressing  his  opinion  as  to  the 
accuracy,  or  otherwise,  of  the  book  values. 

The  auditor  should  not  fail  to  inquire  whether  a 
detailed  record  is  available  showing  the  particulars  of  the 
cost,  etc.,  of  the  machinery.  In  many  factories  such  a 
record  exists,  being  kept  for  insurance  purposes  or  as  a 
check  on  depreciation  charges.  This  record  is  found 
usually  on  cards  or  in  a  loose-leaf  book,  and  as  it  is  not 
considered  one  of  the  regular  books  of  account,  it  wilt 
not  be  submitted  to  the  auditor  unless  he  asks  for  it. 
If  accurate,  it  is  an  invaluable  aid  in  determining  the  value 
of  the  machinery.  The  record  should  show  how  and 
when  acquired ;  cost,  including  installation ;  amount 
reserved  each  year  for  depreciation;  position  in  fac- 
tory; etc. 

Strange  as  it  may  seem,  there  is  a  tendency  towards 
excessive  depreciation  reserves,  particularly  with  respect 
to  certain  machinery  the  important  parts  of  which  can 
be  and  are  renewed  from  time  to  time  and  where  the  cost 
of  such  renewal  is  not  charged  to  the  reserve.  A  manu- 
facturer who  wants  to  be  conservative  will  allow,  say, 
15  per  cent  per  annum  on  machinery.  He  may  set  aside 
this  rate  for  three  or  four  years  and  make  no  charges  for 
renewals  against  it.  Now  when  it  is  applied  to  any  par- 
ticular machine  it  will  be  apparent  at  once  that  it  is  impos- 
sible for  the  machine,  so  long  as  it  is  not  obsolete,  to 
depreciate  more  than,  say,  30  per  cent.     In  other  words, 


BALANCE    SHEET    AUDIT— ASSETS  n^ 

the  machine  could  not  be  operated  properly  if  it  were 
allowed  to  deteriorate  below  70  per  cent  of  its  normal 
condition.  There  is  a  standard  below  which  it  cannot  go 
or  it  could  not  be  operated  at  all. 

There  is  some  basis  of  reason  in  a  factory  manager's 
contention  that  his  plant  is  as  good  as  new.  He  knows 
that  every  machine  is  working  to  its  effective  capacity, 
and  that  any  considerable  depreciation  thereof  is  a  physi- 
cal impossibility  or  he  could  not  produce  a  normal  output. 

There  is,  of  course,  accrued  depreciation  on  every 
machine,  and  this  is  usually  admitted,  sometimes  after  a 
strenuous  argument,  but  the  auditor  who  argues  that  a 
five-year-old  plant  has  depreciated,  say,  50  per  cent,  fails 
to  obtain  a  respectful  hearing,  because,  if  it  were  true,  the 
plant  could  not  be  running,  and  that  fact  is  stronger  than 
his  theories. 

The  real  point  at  issue  is  that  a  considerable  reserve 
for  obsolescence  is  necessary  in  every  plant  where  machine 
tools  and  similar  equipment  are  used.  Depreciation,  as 
such,  cannot  exceed  a  definite  limit,  but  a  machine  which 
would  never  .require  more  than  30  per  cent  or  40  per  cent 
reserve  for  depreciation,  no  matter  what  its  age  may  be, 
should  have  an  obsolescence  reserve  of  perhaps  as  much 
or  more. 

Constant  changes  are  being  made  in  factories  and 
mills.  Machinery  which  is  comparatively  new  is  set  aside 
or  discarded  for  improved  models,  and  this  possibility 
should  influence  the  auditor  who  passes  upon  the  value 
of  such  assets. 

In  some  cases  the  argument  is  advanced  that  the 
superseded  machinery  is  as  good  as  ever  and  is  always 
available  in  case  of  emergency  or  a  sudden  demand  for  an 
increased  output.  This  sounds  plausible,  but  does  not 
work   out   well   in   practice.      The   proper   value   to   place 


Il6  AUDITING 

Upon  such  discarded  machinery,  designated  as  "reserve 
plant,"  is  the  nominal  sum  of  $1. 

Small  Tools 

As  a  rule  the  practice  of  depreciating  this  item  by 
way  of  a  percentage  cannot  be  followed  satisfactorily.  So 
many  small  tools  are  used  up,  or  lost,  or  stolen,  that  an 
inventory  should  be  made  at  periodical  intervals  and  all 
the  tools  on  hand  revalued  for  balance  sheet  purposes. 

If  this  has  not  been  done,  the  auditor  can  fix  his  valu- 
ation only  from  the  best  evidence  available,  but  he  should 
insist  on  a  material  writing-off  from  the  book  values 
unless  liberal  depreciation  has  been  provided  for. 

Furniture  and  Fixtures 

This  is  an  asset  which  has  Httle  residual  value,  and 
conservative  concerns  charge  off  the  larger  proportion 
of  the  cost. 

In  most  establishments  many  items,  such  as  parti- 
tions, special  shelving,  etc.,  are  charged  to  the  fixture 
account,  and  frequent  alterations  and  changes  are  made. 
For  this  reason  most  of  such  expenditure  is  in  the  nature 
of  repairs  and  should  be  charged  off  at  the  time.  If 
charged  to  an  asset  account,  it  should  be  distributed 
ratably  over  one  or  more  years'  operations. 

Where  alterations  are  made  in  leased  premises,  tbe 
auditor  must  be  careful  to  see  that  if  the  lease  is  about 
to  expire  nothing  is  carried  as  an  asset  except  movable 
fittings,  etc.,  and  that  if  removable,  ample  allowance  is 
made  for  deterioration. 

The  auditor  should  not  pass  the  item  of  furniture  and 
fixtures  without  giving  some  thought  to  its  physical  con- 
dition. His  experience  should  furnish  data  as  to  the 
actual  value  of  this  item  and  it  should  be  impossible  to 


BALANCE    SHEET    AUDIT— ASSETS 


117 


induce  him  to  certify  to  an  overvaluation.  The  amount 
of  fire  insurance  carried  thereon  should  be  ascertained. 
Fixtures  attached  to  buildings  should  be  insured  as 
buildings  and  not  as  movable  fixtures.  This  may  be  an 
important  point. 

Containers 

In  certain  lines  of  business,  such  as  breweries,  milk 
depots,  spring-water  dealers,  bakers,  etc.,  a  considerable 
number  of  containers,  such  as  casks,  kegs,  bottles,  cases, 
cracker  tins,  etc.,  are  owned,  which  are  used  for  con- 
venience of  transportation  only  and  are  supposed  to  be 
returned  when  empty.  At  balancing  time  an  accurate 
inventory  should  be  taken,  if  possible,  but  if  not  prac- 
ticable, the  auditor  will  be  under  the  necessity  of  making 
his  own  calculations  as  to  the  number  required  for  the 
normal  operation  of  the  business.  He  should  then  inspect 
the  reserve  supply  and  decline  to  certify  to  a  greater 
number  than  is  thus  disclosed,  unless  furnished  with 
unquestioned  proof  as  to  such  larger  quantity. 

In  many  cases  concerns  go  on  the  assumption  that 
all  such  containers  are  in  possession  of  some  one  who  will 
in  due  course  return  them,  but  experience  proves  that  a 
considerable  percentage  is  lost,  broken,  or  stolen,  and  that 
to  carry  these  as  stock  on  hand  is  a  misstatement  of 
fact. 

Deposits  of  cash  are  frequently  received  as  security 
for  the  return  of  containers,  and  the  aggregate  of  such 
deposits  may  be  large.  If  so,  the  auditor  should  note  the 
relation  of  this  liability  to  the  cash  on  hand.  The  deposits 
constitute  a  trust  fund  and  should  not  be  used  for  working 
capital,  although  it  is  hardly  necessary  to  keep  a  separate 
bank  account  therefor.  The  customers  of  a  large  cracker 
company  returned  empty  tins  in  such  numbers  during  the 


Il8  AUDITING 

panic  of  1907  that  the  cash  required  to  return  their 
deposits  seriously  affected  the  financial  condition  of  the 
company! 

Horses 

Horses  not  only  become  less  valuable  through  age,  but 
depreciate  according  to  the  manner  in  which  they  are 
worked.  A  revaluation  on  the  basis  of  the  age  of  the 
horses  and  the  nature  of  the  business  is  more  satisfactory 
than  the  writing  off  of  a  fixed  percentage  annually.  The 
auditor  should,  if  feasible,  count  the  horses  called  for  by 
the  inventory,  although  he  may  be  unable  to  pass  upon 
their  condition. 

Wagons,  Automobiles,  etc. 

While  these  depreciate  rapidly,  and  in  the  case  of 
automobiles  the  apparent  Hfe  is  short,  yet  it  must  be 
realized  that  the  nature  of  the  items  permits  repairs  to 
be  made  which  largely  take  the  place  of  renewals.  In  an 
automobile,  for  instance,  tires  are  renewed,  the  motor 
may  be  replaced,  and  taxicab  companies  entirely  rebuild 
the  bodies.  Depreciation,  therefore,  as  distinct  from 
repairs  and  renewals  may  be  a  smaller  factor  than  is 
apparent  at  first  glance.  Of  course,  full  allowance  may 
be  made  for  "accrued"  wear  and  tear,  but  any  such  rate 
of  depreciation  for  taxicabs  as  has  been  advocated,  viz., 
three  years,  is  manifestly  excessive  in  view  of  the  fact 
that  many  cabs  are  in  daily  use  which  are  four  or  five 
years  old. 

Patterns,  Drawings,  Lasts,  etc. 

These  items  frequently  represent  large  outlays  by 
manufacturing  concerns  and  form  a  difficult  class  to 
value.     Where  they  are  used  for  stock  or  regular  output, 


BALANCE    SHEET    AUDIT— ASSETS  ng 

their  value  depends  upon  their  Hfe  and  upon  the  prob- 
ability of  renewed  use.  Where  acquired  or  made  for  spe- 
cial jobs,  the  residual  value  is  small,  and  the  book  value 
should  have  been  a  charge  against  the  jobs  themselves. 
In  every  case  these  items  should  be  looked  upon  with  sus- 
picion and  overwhelming  proof  must  be  adduced  before 
passing  any  material  sum  on  their  account  as  an  asset. 
The  auditor  may  meet  with  strong  opposition  in  his 
efforts  to  reduce  this  item  to  a  reasonable  basis,  for  it 
represents  the  skill  and  often  the  affections  of  the  pro- 
prietors, who  dislike  to  hear  its  value  depreciated. 

The  auditor  must,  however,  be  firm  and  decline  to 
set  up  sentimental  values  as  tangible  assets.  The  auditor 
of  considerable  experience  will,  upon  reflection,  recall  the 
small  actual  value  which  this  item  represents. 

The  facts  are  not  difficult  to  ascertain.  The  public 
demands  change,  and  patterns,  etc.,  must  be  made  to  suit 
the  changing  taste.  Likewise,  what  appear  to  be  standard 
'  patterns  for  stable  businesses  change  rapidly.  Engineers 
make  about  as  many  alterations  in  their  ^'styles"  as  do 
milliners.  As  soon  as  demand  ceases  most  of  the  old  pat- 
terns may  as  well  be  scrapped,  and  this  rule  applies  to 
hardware  designs  as  well  as  to  patterns  for  ladies'  dresses. 
More  than  one  balance  sheet  of  a  hardware  manufacturer 
or  a  maker  of  dress  patterns  shows  a  valuation  placed  on 
designs  entirely  out  of  favor. 

The  charges  against  this  account  are  usually  cumula- 
tive, i.e.,  they  follow  the  output  almost  automatically, 
whereas,  if  any  considerable  percentage  of  the  old  pat- 
terns, etc.,  were  available  for  use,  the  additions  to  the 
account  would  not  keep  pace  proportionately  with  the 
production,  but  would  increase  very  slowly.  It  is  incum- 
bent upon  the  auditor  to  apply  these  tests  before  accept- 
ing the  book  valuations. 


I20  AUDITING 

Wherever  feasible  he  should  advise  a  conservative 
course  such  as  writing  down  the  book  value  to  $1. 

Electrotypes,  Woodcuts,  etc. 

The  arguments  just  urged  as  to  patterns  apply  with 
equal  force  to  these  items.  Conservative  publishers  charge 
almost  the  entire  cost  of  plates  as  a  direct  cost  of  a  first 
edition,  and  are  careful  to  revalue  the  balance  of  the 
account  at  frequent  intervals.  If  a  book  or  other  pub- 
lication is  successful,  the  cost  of  plates,  etc.,  can  be  readily 
absorbed  in  its  cost,  while  if  it  is  not  successful,  no  reor- 
ders can  be  looked  for  and  it  would  be  folly  to  carry  the 
plates  in  the  balance  sheet  at  any  valuation  except  as 
scrap  metal. 

A  number  of  bankruptcies  have  occurred  in  the  pub- 
lishing business  through  a  disregard  of  this  fact. 

Patents 

Patents  are  granted  in  this  country  for  seventeen 
years,  so  that  a  proportionate  part  of  their  cost  should  be 
charged  off  periodically  to  provide  for  the  writing  off  of 
the  entire  cost  by  the  expiration  date. 

In  many  cases  a  residual  value  remains  through  the 
building  up  of  good-will  in  connection  with  the  handling 
of  the  patent,  but  this  is  a  different  class  of  asset,  and 
the  auditor  is  not  justified  in  ignoring  the  diminishing 
period.  Other  instances  of  depreciation  affecting  patents 
are  obsolescence,  the  impossibility  of  producing  the  article 
as  a  commercial  or  workable  success,  or  failure  to  induce 
the  public  to  buy  the  patented  article.  It  by  no  means 
follows,  therefore,  that  a  patent  remains  of  value  during 
its  whole  life,  and  consequently  revaluation  in  such  cases 
should  be  resorted  to. 

In   no  event   should   the   value  be  written   up,   even 


BALANCE    SHEET    AUDIT— ASSETS  12 1 

though  it  appears  to  be  much  in  excess  of  the  cost 
price. 

The  auditor  should  see  the  patent  papers,  including 
assignments,  or  secure  a  certificate  from  the  patent  attor- 
neys to  support  the  item. 

The  ledger  caption  of  the  ''Patents"  account  some- 
times is  the  nearest  approach  to  evidence  which  is  called 
for  or  submitted.  If  the  ledger  account  has  been  arbitrar- 
ily so  named  to  ofifset  an  issue  of  capital  stock,  and  is 
not  represented  by  actual  patents  of  any  value,  the 
auditor  should  insist  on  a  renaming  to  accord  with 
the  facts. 

He  has  no  more  right  to  certify  to  a  large  asset  item 
of  "Patents,"  where  the  value  is  not  substantiated,  than 
of  any  other  item  the  meaning  of  which  is  reasonably  clear 
to  the  public,  or  which  they  think  is  clear  to  them. 

As  a  matter  of  fact,  an  auditor  can  form  a  fairly  close 
opinion  on  the  value  of  a  patent.  From  a  commercial 
point  of  view,  if  it  is  an  old  one,  past  results  have  a  dis- 
tinct bearing  on  the  point.  Pending  litigation  furnishes 
another  clue.  If  it  is  a  new  patent,  an  auditor  is  as  well 
qualified  as  anyone  else  to  guess  the  outcome  of  the 
future.  This  is  not  an  argument  to  place  anything  but 
facts  in  the  written  report,  but  this  good  rule  does  not 
bar  an  auditor  from  discussing  the  matter  with  his  client, 
and,  if  requested,  stating  his  experience  in  connection 
with  the  subject. 

Copyrights 

The  same  considerations  apply  to  copyrights  as  to 
patents,  except  that  the  term  is  forty-two  years  or  fifty 
years  after  author's  death.  As  most  copyrights  diminish 
steadily  in  value,  depreciation  should  not  be  based  on 
their  life. 


122  AUDITING 

Revaluation  of  each  one  is  the  only  satisfactory  solu- 
tion. In  all  cases  the  auditor  should  be  furnished  with  a 
list  of  copyrights  owned,  and  inquiry  based  on  this  list 
will  develop  evidence  as  to  the  actual  worth  of  the 
asset. 


CHAPTER    VII 
BALANCE    SHEET    AUDIT— ASSETS    (Continued) 


FIXED  ASSETS   (Continued) 

Good-Will 

This  asset  is  in  a  class  by  itself.  The  question  of  depre- 
ciation certainly  cannot  be  applied  to  it  as  to  other  items. 
If  earnings  decline  for  any  reason,  the  value  of  good-will 
declines  correspondingly,  because  by  its  very  nature  its  value 
depends  on  earnings  of  a  certain  amount  being  maintained. 
Good-will,  however,  always  appears,  or  should  appear,  on 
the  balance  sheet  as  a  separate  item,  and  well-established 
practice  permits  it  to  appear  at  cost,  irrespective  of  fluctua- 
tions which  affect  its  value.  As  a  matter  of  fact,  its  actual 
value  changes  from  day  to  day,  and  there  would  be  so  much 
uncertainty  in  any  attempt  to  adjust  its  book  value  that  by 
common  consent  it  is  left  alone,  except  in  cases  where  earn- 
ings are  unusually  large,  and  it  is  considered  advisable  to 
write  it  off.  In  such  cases  the  very  fact  of  there  being 
sufficient  earnings  to  write  it  off  would  justify  its  reten- 
tion, whereas  earnings  not  up  to  expectations,  and  insuffi- 
cient to  enable  a  concern  to  write  it  off,  would  indicate  that 
its  book  value  is  inflated.  As  good-will  does  not  suffer  wear 
and  tear,  does  not  become  obsolescent,  is  not  used  up  in  the 
operation  of  the  business,  depreciation,  as  such,  cannot  be 
charged  against  it. 

When  it  is  written  off,  a  secret  reserve  may  be  created, 
so  that  no  criticism  can  be  sustained  where  it  is  permitted 
to  stand  at  cost. 

123 


124  AUDITING 

The  intangible  nature  of  good-will  has  made  this  item 
an  easy  excuse  for  manipulation.  Not  long  ago  an  able 
judge  held  that  the  use  of  the  term  "good-will"  to  describe 
overvaluations  had  been  sadly  overdone.  In  the  particular 
case  then  before  him  stocks  and  bonds  had  been  issued  to 
owners  for  their  several  enterprises  and  it  was  obvious  that 
such  payments  included  all  the  good-will  which  could  pos- 
sibly be  ascribed  thereto,  and  that  further,  large  blocks  of 
stocks  and  bonds  handed  to  the  promoters  for  "services" 
constituted  overissues  thereof.  He  also  said  that  the  dummy 
directors  who  solemnly  voted  that  the  properties  acquired 
were  worth  the  price  fixed  by  the  promoters  were  neither 
competent  to  pass  thereon  nor  independent  enough  to  make 
their  decision  binding. 

While  good-will  has  been  said  to  be  the  attractive  force 
which  brings  in  custom,  an  erroneous  idea  sometimes  obtains 
with  respect  to  a  business  which  has  not  earned  more  than  an 
equivalent  of  an  average  rate  of  interest  on  invested  capital, 
plus  a  reasonable  allowance  for  proprietors'  compensation. 
It  is  not  enough  that  such  a  business  be  long  established  with 
a  good  line  of  customers ;  that  prompt  service  and  courteous 
treatment  have  given  prestige  to  the  trade  name ;  that  brands 
or  trade  marks  have  become  household  words;  that  the 
location  is  ideal  and  can  be  continued,  and  that  other  factors 
equally  attractive  are  present. 

In  fact  these  elements  are  negative  rather  than  affirma- 
tive reasons  for  the  consideration  of  a  prospective  buyer, 
because  they  leave  small  opportunities  for  betterment.  And 
if  the  business  has  not  shown  satisfactory  or  increasing 
profits  under  ideal  conditions,  wherein  can  a  purchaser, 
usually  working  at  a  disadvantage  as  compared  with  his 
predecessor,  hope  to  increase  the  profits  to  a  point  which  will 
equal  the  old  business  and  yield  a  further  return  upon  an 
additional  cash  investment  in  good- will? 


BALANCE    SHEET    AUDIT-ASSETS  125 

Good-will,  to  have  a  sales  value,  must  represent  a  sub- 
stantial earning  power  in  excess  of  ordinary  interest  on 
capital  and  management  salaries.  A  losing  business  can- 
not have  any  good-will  unless  there  are  obvious  signs  of 
mismanagement.  The  excuse  of  bad  management  is  over- 
worked and  is  too  often  thought  to  be  a  conclusive  reason 
for  non-success.  Then,  too,  the  profits  should  be  increasing. 
If  the  business  is  standing  still,  the  chances  for  going  back 
are  greater  than  for  improving.  There  can  be  no  certainty 
that  exceptionally  profitable  years  in  the  past,  operat- 
ing to  increase  the  average  over  a  period  of  years,  can  be 
repeated. 

In  the  formation  of  the  International  Harvester  Com- 
pany, the  original  contract  provided  that  the  good-will 
value  of  the  consolidating  units  should  be  fixed  at  the  sum 
of  the  profits  of  the  two  preceding  years,  plus  an  additional 
10  per  cent.  In  commenting  thereon,  the  United  States 
Commissioner  of  Corporations  stated,  "This  method  of 
valuing  good-will  was  more  or  less  commonly  used  among 
manufacturers."  Further  on  in  the  comment,  a  decided 
modification  of  the  rule  appears: 

However,  the  method  of  determining  the  net  profits  was  specifically 
prescribed  in  such  a  manner  as  to  give  a  much  larger  amount  of  profit 
than  that  shown  by  the  companies'  profit  and  loss  accounts.  That  is, 
certain  kinds  of  income  and  expenditure  were  not  included  in  the  com- 
putation, as,  for  example,  interest  on  accounts  and  bills  receivable  and 
interest  on  certain  accounts  payable,  and  cost  of  collecting  receivables. 
Furthermore,  although  the  above  mentioned  contracts  provided  that 
depreciation  should  be  deducted  from  profit,  whether  on  account  of 
plant,  materials  of  manufacture,  or  of  bills  and  accounts  receivable,  yet 
in  the  computation  made  of  good-will  value  by  the  accountants  such 
depreciation  was  not  deducted.  The  final  net  profit  as  fixed  by  the 
accounts  was  not  used,  therefore,  in  this  appraisal  of  good-will,  but 
instead  a  considerably  higher  amount  of  profit  with  a  corresponding 
enhancement  of  the  estimated  value  of  good-will. 

Comments  by  the  United  States  Bureau  of  Corporations 


126  AUDITING 

with  respect  to  good-will  are  of  interest.     The  following 
quotations  are  from  its  reports  on  various  industries: 

•There  are  great  differences  in  respect  to  good-will  between  different 
kinds  of  business.  The  most  important  difference,  probably,  is  that 
between  companies,  on  the  one  hand,  which  sell  a  staple  product  which 
is  bought  and  sold  under  its  staple  name  without  respect  to  the  pro- 
ducer, and  companies,  on  the  other  hand,  which  sell  an  article  under  a 
trade  name  which  is  always  bought  with  the  knowledge  either  of  the 
name  of  the  particular  producer  or  of  the  brand  name  under  which  the 
article  is  sold.  The  latter  kind  of  article  is  generally  advertised  under 
its  trade  name,  and  if  the  business  is  successful  and  expanding  it  has 
a  wide  custom,  of  which  the  concern  making  it  can  not  be  quickly 
deprived  in  the  ordinary  course  of  trade,  even  by  more  efficient  com- 
petitors. 

General  conditions  of  trade  may  undergo  such  changes  that  a 
business  once  profitable  may  become  comparatively 'unprofitable.  The 
opportunities  for  successful  business  operation  may  in  time  be  pretty 
well  exhausted,  either  because  the  needs  of  consumers  are  so  well  sup- 
plied for  a  long  time  ahead  that  demand  slackens,  or  because  of  other 
changes  in  the  trade.  Again,  good-will  based  on  trade  name  and  custom 
may  be  lost  to  some  extent  if  for  any  special  reason  the  article  of  a 
certain  maker  acquires  suddenly  an  unfavorable  notoriety.  In  this  class 
of  conditions  there  is  no  doubt  that  the  so-called  anti-trust  sentiment  is 
an  important  example. 

Undoubtedly  there  is  a  legitimate  value  attaching  to  good-will  in 
the  tobacco  business,  that  justifies  either  valuation  in  excess  of  the 
tangible  assets  or  a  rate  of  income  on  tangible  assets  greater  than  the 
ordinary  rate  of  business  profits  in  enterprises  where  good-will  is  not 
an  important  factor. 

The  element  of  good-will  in  the  tobacco  business  consists  chiefly  of 
what  may  conveniently  be  termed  "brand  value."  At  present  nearly  all 
manufactured  tobacco,  in  whatever  form,  is  sold  under  some  special 
brand  name.  By  means  of  extensive  and  skilful  advertising,  by  a 
superior  combination  of  qualities,  or  sometimes  merely  by  some  good 
fortune  not  easily  explained,  certain  brands  of  tobacco  have  acquired  a 
degree  of  popularity  which  gives  them  a  marked  advantage  over  other 
brands  and  which  even  under  competitive  conditions  enables  the  manu- 
facturer to  realize  a  profit  unusually  high,  and  sometimes  extraordinarily 
so.  Demand  for  particular  brands  of  tobacco  is  based  peculiarly  on  in- 
dividual taste  or  desire  formed  into  a  fixed  preference.  This  preference 
may  have  been  developed  and  fostered,  of  course,  through  various  forms 
of  advertfsing  and  other  schemes  and  inducements  by  the  manufacturer. 


BALANCE    SHEET    AUDIT— ASSETS 


127 


/" 

("GOOD-WILL"  1^ 

\ 

coMPcrmoN 

PERSONNEL 

PENDING  OPOtES 

PUBLICITY 

1 

1 

1 

1 

FWTENT  PiGHtS 

TPADE  NAMCTS 

FPANCHISES 

CPEDtT 

1 

1 

1 

i 

BEPUTATION  TOR 
INTCeCITY 

CONDtTION  OF 
MACKCT 

ESTABLISHED 
LOCATION 

ANNUAL 

EARNINGS 

Some  of  the  factors  that  enter  into  a  computation  of  the  "good  will"  of  a 
business.  For  obvious  reasons  these  factors  vary  greatly  in  importance,  depen- 
dent upon  the  peculiar  conditions  that  affect  the  business  that  enters  into  the 
transaction. 


MULTIPLES  B/ WHICH  GOOD-WILL  HAS  BEEN  ESTIMATEQ  BASED  ON  EARNINGS 

Surplus  Profits  fcr 
"^One^feer 

Usual  Estimate  of 
•Good-Wiir 

fbr  Professional 
Practice 

Tor  ManuTacturinq 
Business 

fbr  Wholesale  or  Ce- 
tail  Trading  Business 

fbr  Quasi  Monopoly 
or  Similar  Business 

ror  Established 
Monopolies 

^ 

1       1 

1    1    1    1 

1    1    1 

II    1    1       II 

1    II    II    II       1       II       1+ 

The  first  rule  in  computing  "good-will"  is  to  determine  the  net  earnings  of 
a  business,  from  which  sum  is  deducted  the  interest  on  capital  actually  employed 
and  the  value  of  the  owner's  services.  The  result,  multiplied  ordinarily  by  two 
but  sometimes  by  many  times  that  amount,  has  been  accepted  as  the  value  of  the 
"good-will." 

Note. — The  above  chart j  are  reproduced  by  permission  from  System  for 
January,    1912. 


128  AUDITING 

It  may  not  necessarily  be  due  to  any  well-defined  intrinsic  qualities  in 
the  brands,  although  a  permanent  demand  for  a  particular  brand  must 
be  more  or  less  based  upon  actual  valuable  qualities  possessed  by  it. 
Brands  of  manufactured  tobaccos  in  this  respect  are  like  many  other 
so-called  proprietary  articles — patent  medicines,  perfumes,  liquors,  toilet 
preparations,  chewing  gum,  etc. — the  manufacturers  of  which  may  and 
often  do  make  exceptional  profits. 

Sinking  Funds 

The  caption  "Sinking  Fund,"  or  any  other  fund,  should 
always  represent  an  asset,  and  inquiry  should  always  be 
made  (whenever  the  nature  of  the  undertaking  raises  the 
question)  as  to  the  disposition  of  this  account.  In  many 
mortgages,  especially  when  secured  by  coal,  ore,  lumber, 
etc.,  it  is  provided  that  a  certain  amount,  based  on  the  pro- 
duction, shall  be  paid  to  trustees  for  the  purpose  of 
extinguishing  the  debt  at  or  before  maturity.  These 
amounts  properly  appear  on  the  balance  sheet  as  assets, 
and  it  should  be  clearly  shown  what  investments  have 
been  made  and  the  cash,  if  any,  which  remains 
uninvested. 

This  principle  is  not  afifected  in  theory  by  the  fact  that 
some  sinking  funds  instead  of  being  actual  assets,  are  de- 
ductions from  liabilities.  For  instance,  a  sinking  fund  may 
be  used  in  buying  up  a  corporation's  own  bonds.  The  actual 
facts  are  better  expressed  if  the  bonds  so  held  (and  which 
may  be  canceled)  are  deducted  from  the  total  outstanding, 
rather  than  shown  as  an  asset. 

A  certifi(^tc_from  the  trustees  as  to  the  state  of  the  fund 
is  sufficient  evidepce  for  the  auditor,  so"^far-as-.the  examina- 
tion of  the  cash  and  securities  is  concerned.  ~^^ 

If  the  bonds  have  been  surrendered  to  the  company, 
the  auditor  should  examine  them  and  note  whether 
proper  safeguards  are  provided  to  prevent  improper 
use  thereof. 


BALANCE    SHEET    AUDIT— ASSETS  129 

The  creation  of  sinking  funds  and  other  points  in  con- 
nection therewith  is  discussed  on  page  194. 

Reserve  Funds 

It  is  not  usual  to  invest  reserves  in  specific  assets.  There 
is  a  strong  feeling  on  the  part  of  theorists  that  an  amount 
equivalent  to  a  reserve  account  created  for  a  specific  purpose 
should  be  invested  in  first-class  securities,  so  that  when  the 
time  arrives  for  the  expenditure  of  the  cash  required  to 
make  good  the  asset  for  the  replacement  of  which  the 
reserve  was  set  up,  it  will  be  available. 

The  theory  is  tenable  where  the  reserve  represents  the 
depreciation  of  a  specific  thing  such  as  a  building  or  a  vessel, 
and  where  it  is  the  intention  to  replace  the  building  or 
vessel  after  its  usefulness  has  ended.  But  most  buildings 
and  vessels  and  similar  assets  are  part  of  general  holdings 
and,  with  rare  exceptions,  more  profitable  use  of  the  fund 
can  be  found  in  the  purchase  of  new  property  or  extensions 
or  additions  to  the  existing  plant,  than  in  the  purchase  of 
stocks  or  bonds  of  other  enterprises.  In  fact,  about  the 
only  argument  against  the  use  of  reserve  funds  in  one's 
own  business  is  the  temptation  to  expand  beyond  safe  limits ; 
and  this  depends  not  so  much  on  the  cash  in  hand  as  the 
ability  to  borrow.  In  other  words,  the  man  who  wants  to 
expand  usually  does  so  to  the  extent  of  his  borrowing  limit, 
and  it  would  be  futile  to  suggest  to  him  the  desirability  of 
investing  reserves  in.  outside  securities. 

If  an  auditor  finds  that  a  fund  exists  representing  in- 
vestments of  reserves,  the  securities  and  the  possible  income 
therefrom  should  be  verified  in  the  usual  way.  ]J.  the 
amounts  reserved  are  suffidentto^  accumulate  the  desired 
aggregate  without  interest,  then  any  income  realized  will 
be  credited  to  prolit  and  loss;  but  if  accumulations  and 
reinvestment  of  income  are  relied  upon  to  add  to  the  fund 


130  AUDITING 

itself,  then  the  auditor  should  ascertain  whether  the  net 
income  collected  is  sufficient  to  carry  out  the  intention. 

Fund  and  Other  Permanent  Investments 

In  this  class  are  included  the  securities  held  for  income 
purposes,  or  as  investments  of  sinking,  reserve,  and  other 
special  funds. 

The  element  of  permanency  consists  in  the  purpose  of 
the  investments,  i.e.,  they  are  not  bought  and  sold  with  a 
view  to  a  profit  in  the  turnover,  nor  are  they  held  as  a 
temporary  reserve  to  be  instantly  converted  into  cash. 

In  many  instances  the  market  price  at  a  particular  date 
may  be  fixed  by  a  few  small  transactions  which  have  little 
bearing  on  actual  values,  owing  to  the  limited  demands,  and 
perhaps  an  urgent  necessity  to  sell  on  the  part  of  an  unfortu- 
nate investor.  The  plan  of  valuing  bonds  which  have  been 
purchased  for  permanent  investment  advocated  by  leading 
authorities  on  the  subject  is  to  compute  their  value  on  the 
basis  of  the  effective,  or  actual  rate  of  interest,  if  held  to 
maturity,  as  determined  by  the  prices  at  which  they  were 
originally  purchased. 

Bonds  are  rarely  purchased  at  par  or  face  value.  To 
make  the  amount  of  the  purchase  equal  the  par  value  at 
maturity  requires  an  adjustment  of  accounts.  The  scientific 
method  of  adjustment  is  known  as  amortization  or  accumula- 
tion and  involves  a  debit  or  credit  to  interest  account  at  each 
periodical  adjustment  of  the  book  value,  in  accordance  with 
the  effective  rate  of  interest,  on  the  basis  of  which  the  in- 
vestment was  made. 

The  corporations  in  whose  balance  sheets  marketable 
investments  play  a  leading  part  are  insurance  companies, 
banks  (more  particularly  savings  banks),  and  trust  com- 
panies. State  laws  require  that  the  solvency  of  insurance 
companies  be  tested  by  the  sufficiency  of  the  assets  (valuing 


BALANCE    SHEET    AUDIT— ASSETS  131 

Stocks  and  bonds  at  the  market  prices)  to  meet  the  present 
value  of  poHcy  contracts  in  force  and  sundry  other  Habili- 
ties.  Owing  to  the  abnormal  decHne  in  the  market  values 
of  securities  in  the  fall  of  1907,  the  statements  of  almost  all 
the  life  insurance  companies  at  December  31,  1907,  showed 
a  startling  decrease  in  surplus  as  compared  with  the  close 
of  the  preceding  year.  This  shrinkage  attracted  consider- 
able attention,  and  as  the  corporate  bonds  owned  (the  fall 
in  whose  market  quotations  was  largely  responsible  there- 
for) were  yielding  the  same  rate  of  income  as  when  pur- 
chased, and  as  there  was  no  serious  question  as  to  the  secur- 
ity of  the  principal  of  most  of  them,  emphasis  was  given  to 
the  question  of  whether  the  basis  of  so-called  market  value 
was  not  an  erroneous  one.  This  rather  startling  object 
lesson  resulted  in  a  more  general  appreciation  of  the  advan- 
tages of  amortization.  A  professional  auditor  should  be 
fully  conversant  with  the  principles  of  amortization  and 
recommend  its  adoption  wherever  possible. 

In  preparing  a  balance  sheet  which  shows  investment 
securities  at  their  amortized  values,  it  is  interesting  and 
advisable  to  mention,  in  a  footnote  or  other  suitable  place, 
the  market  values  at  the  date  of  the  balance  sheet. 

Where  securities  are  purchased  for  a  definite  purpose, 
such  as  the  creation  of  a  fund  to  retire  maturing  obligations, 
the  questions  of  income  and  of  amortization  are  both  im- 
portant. The  auditor  should  in  all  cases  secure  a  copy  of 
the  board  minutes  or  trust  deed  provisions  which  govern 
the  setting  aside  and  handling  of  the  fund.  Any  variation 
therefrom  may  be  important  and  should  be  fully  investi- 
gated. 

If  the  balance  sheet  does  not  disclose  the  fund  properly, 
the  auditor  must  insist  on  its  being  corrected.  Many  cor- 
porate officers  neglect  sinking  fund  and  similar  requirements 
where   the   trustee   fails   to   inquire   periodically    into   the 


132 


AUDITING 


transactions  of  the  corporation,  and  when  their  omissions 
are  called  to  their  attention  they  in  turn  point  out  the  ex- 
cellent financial  condition  of  the  company  and  argue  that 
the  provisions  are  intended  merely  to  safeguard  -the  bond- 
holders from  loss  in  case  the  company  were  unsuccessful, 
and  as  the  contrary  is  the  case,  there  is  no  necessity  for 
bothering  with  the  setting  aside  and  investment  of  a  sinking 
fund. 

Many  bonds  are  secured  by  mortgages  on  personal 
property.  Failure  to  observe  trust  deed  requirements  occurs 
most  frequently  where  there  is  a  sale  of  a  part  of  the  prop- 
erty pledged  under  a  mortgage.  When  obsolete  or  worn- 
out  property  is  sold,  all  proceeds  of  such  sales  are  the 
property  of  the  trustee,  and  any  use  thereof  by  the  corpora- 
tion is  conversion. 

Therefore,  wherever  an  auditor  finds  that  there  has  been 
an  issue  of  bonds  he  should  secure  a  copy  of  the  mortgage 
securing  the  same,  examine  its  provisions,  and  note  any 
apparent  failure  to  observe  them. 

it  may  be  that  resolutions  will  be  found  in  the  board 
minutes  requiring  the  investment  of  part  or  all  of  the  surplus 
in  specific  securities.  The  latter  part  of  the  requirement 
will  not  be  difhcult  to  verify. 

Bonds  and  Mortgages 

Bonds  secured  by  mortgages  upon  real  estate  should  be 
carefully  examined  in  connection  with  the  other  papers 
usually  filed  therewith.  Formerly  such  bonds  were  doulJe 
the  face  of  the  mortgage,  the  reason  being  that  the  mortgage 
itself  could  not  be  converted  into  anything  but  the  real 
property  itself,  thus  leaving  accrued  interest,  taxes,  expenses 
of  foreclosure,  etc.,  unprovided  for.  By  requiring  the  mort- 
gagor to  execute  a  bond  in  a  sum  sufficient  to  cover  all 
such  amounts,  the  result  was  accomplished.     The  present 


BALANCE    SHEET    AUDIT— ASSETS  133 

practice  is  to  write  the  bond  for  the  same  amount  as  the 
mortgage.  Provisions  are  inserted  in  the  bond,  protecting 
the  mortgagee  for  interest,  costs,  etc.  The  mortgage  should 
bear  on  its  face  evidence  of  recording,  and  appear  to  be 
regular  as  to  signature,  etc.,  and  in  a  general  way  be 
identified  with  the  description  contained  in  the  schedule  of 
assets. 

Insurance  and  title  policies  should  be  submitted,  and, 
as  a  rule,  with  certified  appraisals  by  disinterested  experts. 
If  the  mortgage  is  for  a  long  term,  a  recent  appraisal  sjiould 
be  found.  As  to  renewals,  a  new  appraisal  should  be  had 
unless  good  reasons  appear  to  the  contrary. 

Instances  are  known  where  canceled  or  fictitious  mort- 
gages have  been  submitted  as  outstanding  or  genuine.  A 
clever  forger  might  manufacture  documents  which  would 
deceive  those  more  familiar  with  such  papers  than  the 
average  professional  auditor.  Fortunately,  it  is  not  often 
attempted.  The  scrutiny  by  the  auditor  of  all  the  papers 
and  correspondence  usually  accompanying  mortgages,  and 
the  verification  of  the  original  purchase,  and  collections  of 
income  and  principal,  should  disclose  any  irregularities. 
Mortgagors  are  required  to  submit  to  the  mortgagees  their 
paid  tax  bills  annually,  and  it  might  be  worth  while  for  the 
auditor  to  arrange  to  inspect  these  tax  bills  himself  at 
intervals. 

For  further  reference  to  the  examination  of  public 
records,  see  page  156. 

Treasury  Stock 

When  stock  has  been  issued  fully  paid  and  has  been 
returned  to  the  treasury  of  the  company  which  issued  it 
through  purchase  or  gift,  it  is  known  as  "treasury  stock" 
and  should  appear  on  the  books  as  an  asset.  It  represents 
property  of  more  or  less  value  and  is  not  a  deduction  from 


134 


AUDITING 


the  outstanding  capital  stock  unless  it  is  retired  by  due 
process. 

If  purchased  by  the  corporation,  cost  price  is  the  correct 
basis  of  book  entry;  if  acquired  by  gift,  opinions  differ  as  to 
the  form  of  entry.  The  best  authorities  sanction  the  setting 
up  of  the  stock  as  an  asset  at  par  value,  offsetting  this  entry 
by  the  creation  of  a  reserve  or  surplus  account  which  is 
designated  as  a  capital  item,  and  is  clearly  differentiated 
from  the  surplus  which  arises  out  of  profits  or  which  is 
available  for  dividends. 

As  treasury  stock  is  sold  or  otherwise  disposed  of,  the 
asset  account  is  credited  and  an  adjustment  made  between 
this  account  and  the  reserve  or  surplus  account  for  the  dif- 
ference between  the  book  value  and  the  proceeds  of  the  sale. 

For  the  purposes  of  a  balance  sheet  the  auditor  should 
use  his  discretion  and  place  such  a  value  upon  the  stock  as 
in  his  opinion  reflects  its  actual  value.  So  long  as  the  item 
is  separately  and  fully  stated  there  is  no  good  objection  to 
using  the  book  figures.  It  is  never  proper  to  include  among 
the  current  profits  or  as  a  part  of  the  surplus  available  for 
dividends  any  part  of  the  book  value  of  treasury  stock.  This 
would  not,  however,  apply  where  stock  had  been  resold  at 
a  profit  and  the  profit  realized  in  cash. 

In  verifying  the  existence  and  location  of  the  stock  the 
same  rules  should  be  observed  as  with  other  securities. 

Unissued  Capital  Stock 

This  is  to  be  distinguished  from  treasury  stock,  and 
good  accounting  practice  does  not  require  any  entry  there- 
for in  the  books  of  account  until  it  has  been  subscribed  for. 

WASTING  ASSETS 

Certain  assets,  such  as  mines,  lumber,  etc.,  are  in  a  sense 
both  current  and  fixed  in  their  nature,  but  almost  invariably 


BALANCE    SHEET    AUDIT— ASSETS  13  c 

a  considerable  degree  of  permanence  attaches  to  them  and 
as  their  conversion  into  cash  is  a  very  gradual  process,  such 
assets  should  appear  as  a  subdivision  of  those  which  are 
known  as  "fixed." 

Values  to  be  Written  Down 

It  is  obvious  that  a  mine  or  a  tract  of  timber  from 
which  ore  is  being  taken  or  timber  removed  is  worth  less 
at  the  end  of  a  fiscal  period  than  at  its  commencement. 
Consequently  the  balance  sheet  valuation  should  be  reduced 
in  direct  proportion  to  the  depletion  of  the  mine  or  the 
cutting  of  the  timber.  The  usual  reserve  for  depreciation 
is,  or  should  be,  superseded  by  a  sinking  or  extinguishment 
fund  account. 

There  is,  however,  a  decided  difference  between  the 
necessity  for  providing  for  the  renewal  of  plant  and  making 
good  the  diminishing  value  of  a  mine.  In  one  case  it  must 
not  and  cannot  be  assumed  that  there  will  be  no  new  ma- 
chinery to  buy,  whereas  the  owners  of  a  mine  expect  that 
the  product  thereof  will  be  converted  into  cash  and  become 
available  for  distribution  as  dividends,  unless  they  as  owners 
have  decided  to  retain  the  proceeds  and  invest  them  in  other 
ways. 

In  such  cases  the  law  will  not  preveht  the  payment  of 
dividends  out  of  capital,  but  the  by-laws  of  the  board  of 
directors  of  a  corporation  may  make  it  illegal.  The  auditor 
must  acquaint  himself  with  the  facts  relating  to  the  phases 
of  each  particular  case. 

I.  Mines 

The  auditor  should  follow  the  suggestions  relating  to 
land  (page  107)  so  far  as  title  and  encumbrances  are  con- 
cerned. 

In  verifying  the  accuracy  of  the  value  placed  upon  the 


136  '  AUDITING 

mining  property  the  auditor  as  a  rule  will  not  have  much  to 
guide  him.  He  must,  however,  keep  in  mind  the  fact  that 
as  operations  proceed  the  value  decreases.  An  analysis  of 
the  original  cost,  taken  into  consideration  with  the  engineer's 
estimates  of  total  contents,  will  be  a  valuable  check  on  the 
allowance  for  depletion.  It  may  not  be  customary  to  sub- 
mit the  engineer's  records  to  the  auditor,  but  the  latter  is 
on  notice  that  no  well-managed  mining  company  attempts 
operation  on  a  large  scale  unless  fortified  by  the  scientific 
calculations  of  skilled  engineers.  With  these  before  him  and 
with  the  records  of  production  as  shown  by  the  books,  an 
auditor  can  arrive  at  a  reasonable  conclusion  as  to  how  the 
book  valuations'have  been  estimated.  If  his  own  figures  vary 
to  any  great  extent  from  the  books,  the  auditor  should  de- 
cide that  the  matter  demands  further  investigation. 

2.  Timber  Land 

It  will  be  assumed  that  all  timber  propositions  which 
have  arrived  at  a  stage  where  an  audit  is  in  order  are  con- 
ducted on  a  well-thought-out  plan.  The  quantity  of  stand- 
ing timber  will  have  been  estimated  and  verified  (cruised) 
and,  with  this  as  a  starting  point,  the  auditor  can  esti- 
mate the  average  depletion  charge  which  should  be  pro- 
vided for. 

It  is  obvious  that  an  attempt  to  certify  to  results  based 
on  an  examination  of  money  values  only  would  be  hazardous 
to  an  extreme.  The  books  should  show  quantities  as  well. 
If  they  do  not,  the  auditor  is  warranted  in  having  his 
suspicions  aroused. 

CONTINGENT  ASSETS 

The  auditor  rarely  discovers  any  trace  of  assets  which 
have  been  omitted  from  the  books,  but  occasionally  he  is 
fortunate  enough  to  disclose  tangible  assets  which,  when 


BALANCE    SHEET    AUDIT— ASSETS  137 

properly  applied,  increase  the  net  worth  of  the  business 
under  audit;  for  instance,  doubtful  accounts  written  off, 
securities'  deemed  worthless,  or  judgments  not  finally 
awarded  which  become  valuable.  The  author  knows' of  one 
instance  where  a  company  secured  a  judgment  for  $33,000 
for  damages  against  another  solvent  company  several  years 
ago.  The  item  has  never  appeared  upon  the  books  as  an 
asset.  Two  appeals  have  been  taken  and  won,  and  a  final 
favorable  decision  is  expected  in  another  year  or  two.  The 
company's  capital  stock  is  $10,000^,  so  that  the  collection 
of  the  judgment  would  materially  change  its  financial 
position. 

In  addition  to  the  assets  discussed  in  the  foregoing  pages, 
the  auditor  should  consider  the  possibility  of  the  indebted- 
ness to  a  corporation  of  any  person  or  persons. 

Capital  Stock  Calls  and  Assessments 

In  some  states  there  is  a  statutory  liability  on  the  part 
of  stockholders  in  business  corporations  for  an  amount  ad- 
ditional and  equal  to  the  par  value  of  the  shares.  This 
corresponds  with  the  liability  of  stockholders  in  all  national 
banks  and  some  state  banks  and  trust  companies.  The  pos- 
sibility of  such  recovery  is  an  asset  which  should  be  taken 
into  consideration  wherever  it  exists;  the  credit  of  a  com- 
pany incorporated  in  a  state  having  such  a  law  should  be 
strengthened  thereby,  particularly  if  some  or  all  of  its  stock- 
holders are  of  recognized  financial  standing. 

In  other  cases  the  auditor  may  find  that  the  capital  stock 
has  been  only  partly  paid  and  that  the  uncalled  instalments 
are  not  charged  to  the  stockholders  in  the  books,  nor  men- 
tioned in  the  statements.  This  occurs  where  the  corporation 
is  a  close  one  and  the  officers  and  directors  are  identical. 
The  amount  callable  should  be  ascertained  and  the  proba- 
bility of  collection  duly  considered. 


138 


AUDITING 


Liabilities  of  Directors 

In  many  states  directors  are  personally  responsible  for 
debts  contracted  under  certain  circumstances  and  in  excess 
of  certain  sums.  Where  there  is  any  possibility  of  this  con- 
tingency, the  auditor  should  refresh  his  memory  as  to  the 
laws  governing  corporations  of  the  state  in  which  the  com- 
pany is  incorporated,  or  in  which  it  has  its  principal  office, 
and  ascertain  whether  or  not  the  directors  have  automati- 
cally made  themselves  responsible  for  any  part  of  the  in- 
debtedness. This  is  especially  mportant  if  an  examination 
is  being  made  for  creditors. 

SECRET  RESERVES 

After  all  recorded  assets  have  been  dealt  with,  and  after 
due  consideration  has  been  given  to  any  assets  which  have 
been  inadvertently  or  fraudulently  omitted  from  the  records, 
it  may  be  necessary  to  investigate  the  authority  under  which 
assets  have  been  intentionally  omitted  from  the  books  or  the 
balance  sheet,  or  both. 

It-  may  be  perfectly  obvious  to  everyone  connected  with 
the  concern  under  audit  that  certain  assets  exist  and  are 
known  to  be  the  sole-  property  of  the  enterprise,  yet  acting 
under  instructions  from  an  executive  source,  these  assets 
are  never  mentioned  in  the  published  reports  of  the  con- 
cern's financial  standing,  and  may  not  appear  upon  the  books 
of  account.  Or  there  may  be  obvious  undervaluations 
which,  after .  being  so  carried  for  a  number  of  years,  are 
suddenly  written  up  to  their  actual  value. 

As  a  matter  of  fact,  the  auditor  will  not  find  a  great 
many  instances  of  secret  reserves,  but  wherever  he  repre- 
sents stockholders  or  others  who  are  interested  in  knowing 
the  full  value  of  the  assets,  he  should  consider  the  possibility 
of  the  following  improper  treatment  of  accounts  or  assets : 

1.  Systematic  concealment  of  additions  to  plant  or  equip- 


BALANCE    SHEET    AUDIT— ASSETS 


139 


mcnt  by  enlarging  the  cost  thereof  to  maintenance  instead  of 
to  asset  accounts. 

This  practice  must  be  clearly  proven-,  as  it  is  not  in- 
tended to  unreservedly  condemn  the  occasional  charging  off 
of  plant  additions  where  the  obvious  purpose  is  to  be  con- 
servative, and  where  the  cost  is  not  a  material  factor  in  the 
operations  of  the  period.  But  if  it  is  evident  that  a  con- 
siderable sum  has  been  expended  in  improvements  and  there 
is  no  reflection  thereof  in  the  accounts,  then  the  auditor 
should  insist  on  restating  the  accounts  and  bring  out  clearly 
the  actual  earnings  of  the  period. 

2.  The  creation  of  excessive  reserves  for  depreciation, 
bad  debts,  or  similar  items,  unless  the  fact  that  the  reserves 
are  excessive  is  expressed  on  the  face  of  the  balance  sheet. 

This  is,  perhaps,  the  favorite  method  of  deceiving  minor- 
ity stockholders  when  the  directors  or  other  insiders  wish 
temporarily  to  understate  the  earnings  as  well  as  the  assets. 

It  is  not  intended  to  condemn  at  this  point  the  practice 
of  setting  aside  what  may  appear  to  be  excessive  reserves 
in  order  to  keep  down  taxes.  In  many  instances  during 
recent  years  corporations  have  provided  heavy  depreciation 
reserves  in  order  to  avoid  the  payment  of  state  and  federal 
taxes  on  earnings  and  assets.  Usually  this  is  done  in  close 
corporations  and  each  stockholder  is  fully  informed  as  to 
what  is  being  done.  In  such  cases,  where  the  reserves  are 
officially  created,  the  auditor  can  hardly  object  to  the  state- 
ment of  the  accounts  as  they  appear  on  the  books. 

In  the  natural  course  of  events  the  state  and  national 
taxes  will  be  paid  because  the  understatement  of  profits  is 
temporary  and  the  profits  of  future  years  may  be  expected 
to  reflect  the  working  out  of  the  reserves. 

The  auditor  is  so  accustomed  to  these  reserves  being  in- 
sufficient that  he  feels  reluctant  to  criticize  liberal  allow- 
ances, unless  there  is  an  apparent  desire  to  defraud  innocent 


146 


AUDITING 


stockholders.  Otherwise,  he  commends  the  disposition  to  be 
conservative,  and  watches  with  interest  the  final  outcome 
of  the  reserves. 

The  taxing  powers  are  prone  to  exact  their  pound  of 
flesh  and  rarely  provide  the  means  whereby  an  overpayment 
for  one  year  may  be  applied  in  reduction  of  subsequent 
assessments. 

Until  our  systems  of  taxation  are  founded  on  reason  and 
some  knowledge  of  business  and  accounting  procedure,  at- 
tempts to  avoid  overpayments  may  naturally  be  expected, 
and  if  such  attempts  produce  underpayments  the  fault  may 
fairly  be  charged  jointly  to  those  responsible  for  the  tax 
legislation  and  to  those  intrusted  with  the  enforcement  of 
the  laws. 

3.  Inventories  should  reflect  fair  values,  as  explained  in 
Chapter  V,  hut  there  is  a  limit  beyond  zvhich  valuations  can- 
not be  reduced,  unless  the  circumstances  of  the  reduction  are 
stated  on  th^e  face  of  the  balance  sheet. 

This  rule  is  of  somewhat  greater  importance  than  the 
preceding  one,  because  reserves  stand  out  to  a  certain  extent 
and  grossly  excessive  reserves  are  apparent,  but  if  an  in- 
ventory is  undervalued,  anyone  unacquainted  with  the  fact 
is  not  able  to  detect  the  fraud,  no  matter  how  carefully  the 
balance  sheet  might  be  analyzed.  If  there  is  an  honest  de- 
sire to  be  ultra-conservative  and  write  something  off  the 
inventory  after  it  has  been  properly  valued,  it  should  be 
accomplished  by  creating  a  "reserve  for  possible  loss  on 
realization  of  inventory"  and  setting  up  this  reserve  on  the 
balance  sheet,  with  a  footnote  stating  that  the  inventory 
itself  is  not  excessive. 

If  those  responsible  for  the  balance  sheet  valuations  wish 
to  write  down  the  inventory,  but  do  not  want  the  fact  re- 
flected in  the  balance  sheet,  the  auditor  is  put  on  notice  that 
an  attempt  is  being  made  to  deceive  some  one.     The  lack 


BALANCE     SHEET    AUDIT— ASSETS  141 

of  a  good  reason  for  concealing  the  truth  is  pri}na  facie  evi- 
dence of  dishonesty  and  the  auditor  should  act  accordingly. 

4.  The  circumstances  surrotmding  the  ziriting  down  of 
assets  must  be  carefully  looked  into.  ^^ 

So  many  assets  are  overvalued  that  it  is  usually  refresh- 
ing for  an  auditor  to  discover  a  willingness  to  write  down 
overvaluations  out  of  profits.  Instances  are  known,  how- 
ever, where  such  adjustments  have  been  so  stated  as  to 
conceal  their  true  import  and  minority  stockholders  have  lost 
thereby. 

In  all  cases  the  full  earnings  of  a  period  should  be 
shown,  and  if  it  is  desirable  to  write  off  assets,  such  as 
good-will,  or  write  down  overvaluations,  such  items  must 
appear  as  extraordinary  deductions  and  not  applicable  solely 
to  the  period  under  review.  If  the  accounts  are  so  stated, 
no  fault  can  be  found  therewith.  A  stockholder  who  does 
not  understand  accounts  may  look  at  the  final  figures  and 
form  an  erroneous  conclusion  as  to  the  actual  profit  of  the 
period,  but  if  there  is  no  attempt  to  deceive  and  if  the  ac- 
counts are  clearly  set  forth,  the  stockholder  is  simply  suffer- 
ing the  penalty  of  his  ignorance. 

There  does  not  appear  to  be,  from  an  accounting  stand- 
point, any  justification  for  flagrant  undervaluations  under 
any  circumstances,  but  as  the  practice  has  supporters  among 
some  very  reputable  financiers,  it  is  at  least  in  order  to 
examine  the  arguments  used  in  support  of  secret  reserves. 
The  principal  argument  is  that  stockholders  are  notoriously 
hungry  for  dividends,  and  a  surplus  available  (in  their 
opinion)  for  dividends,  but  not  so  distributed,  reflects  no 
credit  whatever  on  the  management,  but  quite  the  contrary. 
On  the  other  hand,  if  the  profits  of  the  good  years  are  all 
divided  so  that  when  the  inevitable  poor  year  arrives  the 
dividend  must  be  passed,  there  is  bitter  criticism.  Some 
boards  of  directors  think  that  stockholders  as  a  class  must 


42 


AUDITING 


not  have  full  information  for  their  own  good ;  therefore, 
in  order  to  avoid  criticism,  the  profits  of  the  good  years  are 
not  fully  disclosed  and  dividends  are  continued  through  the 
unprofitable  periods. 

Banks  and  trust  companies  assume  this  patriarchal  atti- 
tude more  frequently  than  is  the  case  with  industrial  cor- 
porationsi  Perhaps  there  is  some  justification  for  this 
practice  on  the  part  of  banks  whose  stockholders  rarely 
change  and  where  dividends  are  largely  depended  upon  for 
living  expenses. 

With  respect  to  the  banking  house  and  equipment,  there 
can  be  little,  if  any,  objection  to  writing  down  their  value 
to  a  nominal  amount.  Except  in  a  few  localities,  bank 
buildings  and  bank  furniture  are  not  assets  which  can  be 
realized  upon  to  pay  depositors.  The  building  occupied  by 
a  failed  bank  is  not  an  attractive  place  for  another  bank  to 
start  business  in,  and  such  buildings  are  rarely  suitable  for 
anything  else.  It  may  be  proper,  therefore,  for  a  bank  to 
write  down  its  property  account  to  the  actual  value  of  the 
land  and  the  auction  value  of  its  furniture,  vaults,  etc.  This 
is  a  secret  reserve  on  the  basis  of  a  going  business,  but  as 
banks  publish  frequent  statements  of  their  assets,  no  one 
who  owns  stock  and  who  desires  to  ascertain  the  book 
value  of  the  stock  need  be  deceived. 

Of  course,  if  a  bank's  premises  are  also  occupied  by 
tenants  who  pay  remunerative  rentals,  this  fact  should  be 
taken  into  consideration  in  writing  down  the  book  valua- 
tions. It  might  be  fair  to  assume  that  if  a  sudden  demand 
for  funds  were  made  and  it  became  necessary  to  sell  the 
building,  a  price  could  be  immediately  realized  which  would 
represent  the  capitalized  valuation  of  the  property,  assum- 
ing that  the  bank's  own  quarters  would  not  yield  any  return. 

There  are  few,  if  any,  other  classes  of  enterprises  where 
there  is  any  justification  for  writing  down  the  cost  or  value 


BALANCE     SHEET    AUDIT— ASSETS  143 

of  assets  in  order  to  provide  a  secret  reserve  to  be  held  in 
abeyance  for  the  purpose  of  continuing  dividends  on  a  con- 
stant basis.  The  stockholders  of  industrial  corporations  do 
not  have  as  good  an  opportunity  of  forming  an  opinion 
upon  published  balance  sheets  as  the  stockholders  of  banks. 
They  must  rely  on  the  accuracy  of  the  amount  which  is 
reported  as  the  net  profit  for  the  period.  Such  stock  changes 
hands  more  frequently  than  bank  stock. 

It  is  apparent  that  a  stockholder  who  desires  to  sell  and 
who  fixes  a  price  upon  his  stock  based  upon  the  reported 
earnings  of  the  last  period  is  at  a  great  disadvantage  with 
a  prospective  purchaser  of  his  stock,  who  may  know  that  the 
full  earnings  were  not  disclosed  by  the  report  but  that  a 
part  of  the  profit  was  diverted  to  a  secret  fund  which  it  was 
proposed  to  use  subsequently  to  bolster  up  an  unusually 
unprofitable  period. 

It  has  been  argued  that  good  faith  on  the  part  of  the 
management  should  be  the  sole  test  of  whether  or  not  such 
transactions  be  acceptable  enough  to  a  professional  auditor 
to  warrant  his  certifying  to  a  balance  sheet  and  profit  and 
loss  account  in  which  they  appear. 

An  auditor  can  give  advice,  but  he  cannot  control  the 
action  of  a  board  of  directors,  nor  in  this  country  does  he 
communicate  directly  with  the  stockholders  of  a  corpora- 
tion. What  should  he  do  when  he  is  asked  to  certify  to  a 
statement  which  he  believes  contains  all  of  the  facts  and 
figures  which  the  board  of  directors,  acting  for  the  stock- 
holders and  for  their  interests,  think  they  should  have, 
but  which  conveys  a  false  impression  in  that  the  profits 
are  understated  owing  to  the  creation  of  a  secret  reserve? 

The  auditor  who  finds  himself  in  such  an  uncomfortable 
situation  has  but  one  course  to  pursue;  he  should  send  in 
his  report  setting  out  the  true  facts  as  he  has  found  them, 
and  commenting  upon  the  asset  valuations  of  which  he  can- 


144.  AUDITING 

not  approve.  The  directors  cannot  publish  the  report  unless 
the  existence  of  the  secret  reserve  is  disclosed.  If  they  do 
not  publish  the  auditor's  report,  but  put  out  an  uncertified 
balance  sheet,  the  auditor  can  do  nothing. 

It  might  not  be  a  bad  idea  to  urge  every  stockholder 
proposing  to  sell  his  stock  to  call  for  a  professional  auditor's 
report  upon  the  accounts  and  affairs  of  the  corporation 
before  the  sale  is  consummated,  but,  unfortunately  for  pro- 
fessional auditors,  the  value  of  their  certificates  is  not  yet 
appreciated  by  the  majority  of  investors.  When  a  man  buys 
a  horse  he  wants  it  examined  by  an  expert  on  horses;  so 
he  calls  in  a  veterinarian.  He  knows  less  about  accounts 
and  values  than  he  does  about  horses,  but  he  does  not  think 
of  calling  in  an  expert  on  values  or  accounts  when  he  buys 
or  sells  a  share  of  stock.  He  has  heard  about  the  value  of 
the  services  of  a  veterinary  since  his  childhood,  but  he  does 
not  know  that  the  absence  of  an  auditor's  certificate  from 
a  balance  sheet  may  indicate  that  the  assets  shown  therein 
are  improperly  stated,  and  that  if  he  decides  to  sell  because 
the  business  does  not  appear  to  be  as  prosperous  as  he 
thought  it  would  be,  his  action  is  exactly  in  line  with  the 
intention  of  the  insiders,  who  promptly  buy  out  all  those 
who  have  become  discouraged. 

The  fact  of  the  matter  is  that  an  auditor  Is  taking  big 
chances  when  he  passes  a  balance  sheet  which  conceals  or 
understates  assets.  Good  faith  may  be  only  apparent,  the 
real  purpose  of  the  management  being  to  buy  the  interests 
of  the  misinformed. 

In  no  event,  however,  should  an  auditor  certify  to  a 
balance  sheet  from  which  any  asset  has  been  omitted  en- 
tirely. The  arguments  in  favor  of  an  undervaluation  are 
weak  enough,  supported  as  they  are  by  the  general  assertion 
that  the  item  speaks  for  itself  in  the  balance  sheet,  but  there 
can  be  no  argument  at  all  to  support  the  complete  omission 


BALANCE    SHEET    AUDIT— ASSETS 


US 


from  the  asset  side  of  the  balance  sheet  of  any  item  of 
property,  tangible  or  intangible,  which  has  or  may  have  a 
market  value. 

The  auditor  who  knowingly  certifies  to  such  a  statement 
can  be  held  responsible,  and  money  damages  recovered,  by 
any  stockholder  parting  with  his  stock  on  the  basis  of  the 
balance  sheet  figures.  Such  an  action  would  be  founded 
on  a  charge  of  deceit  or  fraud  depending  upon  the  circum- 
stances of  each  case. 

Ernest  Reckitt,  C.P.A.,  has  said  on  this  point: 

The  shareholders  of  a  corporation  have  certainly  a  right  to  know 
the  real  value  of  the  tangible  assets,  the  estimated  value  of  the  good- 
will, and  how  much  "water"  there  is  in  the  stock,  and  any  statement 
which  does  not  separate  these  items  should  be  looked  upon  with  sus- 
picion. A  shareholder  is  entitled  to  his  pro  rata  share  of  the  whole 
profit  between  regular  fiscal  periods  during  the  time  he  is  a  shareholder. 
He  may  not  receive  his  profit  entirely  in  the  form  of  dividends,  but 
that  portion  of  the  corporation's  profits  which-  is  not  paid  out  in  divi- 
dends, but  left  in  surplus,  should  be  so  presented  to  the  public  that, 
other  things  being  equal,  the  selling  price  of  the  stock  will  correspond- 
ingly increase,  and  the  shareholder  will  receive  the  balance  of  his  profits 
upon  the  sale  of  his  stock.  It  is  for  these  reasons  that,  in  my  opinion, 
the  public  accountant  should  refuse  to  countenance  the  "secret  reserve" 
or  any  other  action  which  makes  it  difficult  for  the  layman  to  determine 
the  true  financial  condition  of  the  company  in  which  his  funds  are 
invested. 

The  shareholder  has  too  frequently  been  considered  as  a  child, 
from  whom  it  might  be  advisable  to  keep  certain  facts.  I  believe  this 
condition  of  affairs  is  fast  disappearing,  and  that  the  best  co-operation 
is  attained  by  the  directors  taking  their  shareholders  into  their  con- 
fidence, and  if  there  is  "water"  in  the  stock,  let  them  separate  it  from 
the  rest  of  the  assets,  and  then,  at  the  close  of  the  year,  the  total 
additions  to  the  plant  should  be  charged  to  plant  account,  and  an 
entry  of  like  amount  could  be  made  crediting  good-will  or  franchise 
account  and  charging  surplus,  instead  of  charging  the  additions  of  the 
year  direct  to  surplus,  and  thus  clouding  the  issue. 


CHAPTER    VIII 

BALANCE    SHEET    AUDIT— LIABILITIES 

In  a  balance  sheet  audit  nothing  is  more  important  than 
to  ascertain  whether  or  not  all  the  liabilities  of  any  nature 
whatsoever  appear  and  are  properly  stated. 

At  the  outset  of  this  chapter  it  may  be  proper  to  illus- 
trate this  point  in  order  that  the  auditor  will  realize  the 
importance  of  placing  himself  in  the  position  of  the  one  who 
will  read  the  balance  sheet  later. 

Bankers  extend  credit  to  trading  concerns,  not  to  furnish 
additional  capital,  but  to  assist  them  to  carry  stock-in-trade, 
or  accounts  receivable,  at  their  busy  season,  and  they  expect 
to  have  the  borrowings  repaid  or  materially  reduced  during 
the  dull  season.  Therefore  the  balance  sheet  of  a  trading 
concern  is  always  scanned  closely  by  the  banker  to  deter- 
mine the  proportion  of  current  assets  to  current  liabilities, 
and  he  calculates  the  time  within  which  the  stock-in-trade 
should  be  realized  upon.  Now  it  may  be  that  the  concern 
has  contracted  to  purchase  large  quantities  of  goods  which 
have  not  been  received,  and  these  contracts  may  call  for 
large  cash  payments  within  a  comparatively  short  time. 
Furthermore,  the  contracts  may  have  been  made  on  a  de- 
clining market,  and  the  goods  to  arrive  may  cost  more  than 
would  have  been  the  case  if  not  contracted  for  in  advance. 
This  information  would  not  appear  on  the  regular  books  of 
account,  but  is  it  not  the  kind  of  information  which  the 
banker  requires  to  make  up  his  mind  in  passing  upon  the 
desirability  of  the  risk,  and  is  it  not  the  kind  of  information 

146 


BALANCE     SHEET    AUDIT— LIABILITIES  147 

which  an  auditor  should  seek  in  order  to  be  of  substantial 
value  to  his  client? 

The  following  rules  relative  to  the  borrowing  and  loan- 
ing of  money  were  prepared  by  very  able  authorities : 

1.  The  purpose  for  which  the  borrowed  money  is  to  be 

used  should  produce  a  return  greater  than  is  needed 
to  pay  the  debt. 

2.  The  length  of  time  the  debt  is  to  run  should  have  a 

close  relation  to  the  productive  life  of  the  improve- 
ment for  which  the  money  is  borrowed. 

3.  Provision  should  be  made  in  long-time  loans  for  the 

gradual  reduction  of  the  principal. 
The  auditor  who  limits  himself  to  an  examination  of 
the  formal  books  of  account  in  making  an  audit  is  pre- 
venting himself,  in  many  cases,  from  being  of  constructive 
value,  and  in  other  cases  he  is  approaching  the  limits  of 
liability  in  money  damages  for  negligence  in  not  doing  all 
that  a  skilful  and  experienced  auditor  should  do.  It  is 
conceded  that  when  an  auditor  assumes  to  pass  on  matters 
which  are  not  in  the  books  he  is  opening  up  a  wide  field, 
and  perhaps  a  troublesome  one  to  cover,  but  it  may  as  well 
be  admitted  that  the  ordinary  so-called  checking  of  books, 
and  the  subsequent  balance  sheet  prepared  therefrom,  are 
about  as  valuable  to  the  banker  or  other  creditor  as  the 
information  which  the  borrower  can  and  does  furnish  him- 
self. 

Accounts  Payable 

The  ideal  course  by  which  to  satisfy  oneself  that  all 
obligations  to  trade  creditors  appear  in  the  books  at  the 
balance  sheet  date  would  be  to  read  all  the  incoming  mail 
for  some  days  before  and  after  such  date.  The  period  prior 
would  yield  information  as  to  the  original  invoices  for  pur- 
chases, and  during  the  subsequent  days  ordinary  monthly 


148 


AUDITING 


statements,  followed  later  by  polite  requests  to  pay,  would 
show  practically  all  of  the  class  of  debts  mentioned.  The 
mail  would  likewise  bring  notices  of  maturities  of  promis- 
sory notes. 

Unfortunately,  the  auditor  rarely  has  an  opportunity  to 
open  the  mail  of  his  clients,  although  it  might  shed  light  on 
more  items  than  accounts  and  notes  payable.  In  the  ab- 
sence of  this  short  cut  an  auditor  must  first  see  to  it  that 
all  the  accounts  payable  shown  on,  or  indicated  by,  the  books 
are  reflected  in  the  balance  sheet,  and,  second,  he  must  con- 
duct a  proper  investigation  to  ascertain  whether  any  ac- 
counts payable  actually  due  by  the  concern  under  audit, 
and  not  shown  on  the  books,  should  be  included  among  the 
liabilities.  The  procedure  in  such  an  investigation  is  ex- 
plained hereafter. 

The  auditor  cannot  foresee  the  use  to  which  a  balance 
sheet  may  be  put,  so  that  it  is  always  his  duty  to  use  plain 
terms  and  classify  the  liabilities  so  that  any  pertinent  ques- 
tion which  arises  in  the  mind  of  an  interested  person  may 
be  answered  without  the  necessity  of  a  special  examination 
for  each  question.  It  is  not  enough  to  state  the  aggregate 
of  the  debts  of  a  firm  or  corporation,  unless  it  is  desired 
that  it  shall  be  understood  that  all  consist  of  open  accounts 
payable,  incurred  in  the  regidar  course  of  business,  not  due, 
and  for  which  value  has  been  received.  If  various  classes 
of  debts,  incurred  in  other  than  the  regular  course  of  busi- 
ness, are  included  in  one  sum,  it  has  been  made  impossible 
for  anyone  not  familiar  with  the  facts  to  express  a  reliable 
opinion  upon  the  financial  position  of  the  concern. 

For  instance,  it  might  appear  that  a  firm  had  assets  of 
$100,000,  consisting  chiefly  of  accounts  and  stock-in-trade, 
and  accounts  payable  of  $25,000.  If  the  latter  were  not 
due  it  would  be  a  fair  inference  that  the  accounts  receivable 
and  merchandise  stock  would  be  liquidated  quickly  enough 


BALANCE     SHEET    AUDIT— LIABILITIES  149 

to  pay  the  obligations  as  they  matured.  But  suppose  it  were 
shown  that  some  of  the  accounts  payable  were  long  over- 
due; that  the  accounts  receivable  were  very  slow;  that  the 
merchandise  stock  was  selling  poorly ;  and  that  cash  receipts 
were  being  used  to  pay  wages  and  similar  expenses.  Would 
this  make  a  favorable  showing  in  the  eyes  of  a  banker  who 
might  be  considering  the  advisability  of  extending  a  line  of 
credit  ? 

Of  course  a  firm  in  such  a  condition  might  deserve  the 
confidence  of  a  banker,  and  there  might  be  ample  security 
for  a  reasonable  line  of  credit,  but  no  auditor  would  be  justi- 
fied in  merely  stating  the  bald  facts  as  shown.  If  the  auditor 
does  not  feel  warranted  in  adding  a  few  words  of  comment 
to  convey  unequivocally  that  the  assets  were  not  readily 
realizable  and  that  the  accounts  payable  were  long  overdue, 
then  his  point  of  view  is  too  far  apart  from  the  author's. 
The  latter  can  be  of  but  scant  service  to  one  whose  concep- 
tion of  an  auditor's  duty  is  that  it  requires  him  to. state 
so-called  facts  only.  The  principal  reason  why  some  busi- 
ness men  feel  that  professional  auditors  cannot  help  them 
is  that  they  have  been  unfortunate  enough  to  hear  the 
words  and  see  the  figures  which  emanated  from  an  auditor 
who  felt  that  he  exceeded  the  limits  of  propriety  if  he 
ventured  an  opinion  upon  any  important  item  of  the 
balance  sheet. 

It  is  a  reasonable  assumption  that  no  balance  sheet  pre- 
pared within,  say,  twenty  days  of  a  centain  date,  exhibits 
every  liability.  No  exception  is  made  for  those  concerns 
which  maintain  an  inflexible  order  system  and  where  the 
books  are  not  closed  until  every  order  issued  is  represented 
by  a  purchase  invoice.  It  is  always  found  that  some  one 
has  ignored  the  rules  and  ordered  something  for  which  a 
liability  exists,  or  it  may  be  for  an  expense  which  does  not 
require  an  order ^  such  as  long  distance  telephone  calls  or 


I50  AUDITING 

lawyers'  bills.  Taxes  of  which  little  is  known  may  be 
accruing,  or  goods  may  not  have  been  delivered  to  a  cus- 
tomer who  has  refused  to  accept  them,  and  return  freight 
charges  and  storage  may  have  accrued.  The  best  the 
auditor  can  do  is  to  schedule  all  of  the  liabilities  to  which 
he  can  find  the  slightest  clue. 

So  many  balance  sheets  have  been  issued  which  have 
failed  to  include  all  of  the  liabilities  that  the  author  feels  jus- 
tified in  discussing  the  matter  fully,  in  order  that  the  stu- 
dent may  have  the  benefit  of  accumulated  experience. 

Trade  Creditors 

This  may  not  be  the  largest  item  of  the  liabilities,  but  it 
is  clearly  the  most  important  to  verify.  The  notes  payable 
outstanding  may  be  larger  in  amount,  but  the  proceeds 
thereof  were  presumably  used  to  discharge  trade  debts,  so 
that  the  latter  item  loses  none  of  its  importance  because  the 
balance  is  small. 

As  already  stated,  an  auditor  might  ascertain  the  total 
amount  of  the  debts  by  examining  all  of  the  mail  over  a 
sufficiently  long  period,  but  as  this  procedure  is  perhaps  out 
of  the  question,  he  must  do  the  next  best  thing. 

Statements  from  creditors  are  valuable  in  verifying  the 
amount  due  or  claimed  to  be  due,  and  if  the  time  permitted 
(which  it  usually  does  not)  the  auditor  could  do  no  better 
than  to  request  a  statement  from  everyone  with  whom  the 
concern  might  be  expected  to  do  business.  Even  then  some 
one  from  whom  a  purchase  had  been  made  might  be  for- 
gotten, the  invoice  might  be  omitted  from  the  books,  and 
the  fact  concealed  from  the  auditor. 

Most  concerns  keep  order  and  receiving  records  of 
some  description.  The  auditor  should  compare  the  entries 
in  this  record  during  the  period  immediately  preceding  the 
balance  sheet  date,  with  the  purchase  journal  or  voucher 


BALANCE     SHEET    AUDIT— LIABILITIES  jci 

record  to  ascertain  if  the  purchases  indicated  are  entered. 
Every  entry  need  not  be  checked.  It  is  necessary  to  test 
only  enough  of  the  work  to  be  satisfied  that  no  invoices 
have  knowingly  or  unknowingly  been  suppressed. 

Where  an  audit  is  not  completed  until  more  than  a 
month  has  elapsed  after  the  closing  date,  the  voucher 
record  should  be  scrutinized  to  ascertain  whether  invoices 
entered  subsequently  belong  to  the  prior  period. 

The  open  accounts  on  the  ledger  should  be  compared 
with  the  schedule  of  accounts  payable.  It  should  be  ascer- 
tained that  the  balances  represent  specific  and  recent  items 
only.  If  not,  why  not  ?  Where  any  account  does  not  look 
regular  in  every  way  the  statement  from  the  creditor  should 
be  asked  for.  If  it  cannot  be  found,  request  a  duplicate.  If 
told  that  the  creditor  does  not  send  statements,  demand 
that  one  be  procured.  The  latter  excuse  is  often  made,  but 
almost  inva^riably  it  follows  an  inquiry  relative  to  a  disputed 
account  and  where  the  ledger  shows  a  less  amount  to  be 
due  than  is  claimed.  Nearly  all  business  houses  do  send 
statements  either  on  a  fixed  day  each  month  or  as  bills  fall 
due.  The  author  has  never  heard  of  a  refusal  to  furnish 
a  duplicate,  or  to  furnish  a  memorandum  of  the  amount 
due  at  any  stated  time. 

As  a  test,  call  for  certain  statements  in  every  case,  even 
if  none  of  the  accounts  appear  irregular.  Disputes  occur 
so  frequently  over  discounts,  allowances,  returns,  etc.,  that 
it  may  be  the  auditor's  only  chance  to  test  the  reliability  of 
the  purchase  records. 

The  inspection  of  the  order  and  receiving  books  is  also 
important  in  that  it  may  disclose  receipts  of  goods  at  or 
before  inventory  time  the  invoices  of  which  are  not  en- 
tered, the  reason  given  for  the  omission  being  that  as  the 
goods  were  received  late  it  was  not  considered  worth  while 
to  add  them  to  the  inventories,  or  to  pass  the  invoices 


152 


AUDITING 


through  the  books  until  after  the  closing  date.  If  this 
practice  involves  a  few  items  of  small  amount  only  it  is 
not  worth  condemning,  but  if  the  quantities  and  amounts 
are  relatively  large  the  auditor  must  add  the  goods  to  the 
inventory  and  the  amounts  of  the  invoices  to  the  accounts 
payable. 

When  examining  the  receiving  and  other  records  for 
evidence  of  purchases  not  represented  by  entries  in  the 
books,  it  should  be  remembered  that  the  date  of  an  in- 
voice may  not  represent  the  date  of  its  shipment,  the  prac- 
tice of  "dating"  (i.e.,  dating  an  invoice  forward  to  some 
future  time)  being  not  at  all  uncommon. 

It  is  assumed  that  the  ledger  balances  represent  the 
amounts  due  after  trade  discounts  have  been  deducted  but 
before  cash  discounts  are  taken  into  consideration.  Trade 
discounts  should  not  appear  on  the  books  of  account,  being 
direct  deductions  from  list  prices.  In  respect  to  cash  dis- 
counts, however,  the  practice  is  not  uniform.  Some  con- 
cerns take  advantage  of  every  cash  discount  and  make  the 
deduction  immediately  upon  receipt  of  the  invoice  and  be- 
fore it  is  entered.  Where  this  has  been  done  the  auditor 
need  not  hesitate  to  pass  the  accounts  as  they  stand,  but 
where  the  deductions  have  not  been  made  the  auditor 
should  be  governed  by  the  size  of  the  discounts.  Where 
the  allowance  is  1  per  cent  for  payment  within  ten  days,  or 
where  the  rate  is  lower,  the  amounts  due  should  be  taken 
at  their  face.  This  gives  the  period  following  the  balance 
sheet  date  the  benefit  of  the  earning,  but  it  is  not  out  of 
proportion  to  the  cash  required  and  the  expense  of  salaries, 
postage,  etc.,  incurred.  On  the  other  hand,  if  the  allowance 
is  more  than  1  per  cent  for  prepayment,  and  if  the  concern 
has  ample  funds  to  pay  all  maturing  accounts,  it  may  rea- 
sonably be  urged  that  the  earning  belongs  to  the  period 
preceding  the  closing  of  the  books.     For  instance,  an  in- 


BALANCE    SHEET    AUDIT— LIABILITIES  153 

voice  for  $1,000  may  be  dated  June  23,  "thirty  days  net, 
2  per  cent  ten  days."  It  could  hardly  be  urged  that  on 
June  30  the  liability  would  be  more  than  $980,  provided 
that  the  cash  balance  indicated  that  the  discount  would  be 
taken  advantage  of. 

If  the  auditor  desires  to  adjust  the  accounts  in  accord- 
ance with  this  suggestion,  it  will  be  necessary  only  to  note 
the  actual  deductions,  per  cash  book,  during,  say,  the  first 
half  month  succeeding  the  balance  sheet  date,  allowing 
for  any  possible  items  arising  out  of  new  transactions. 
This  would  obviate  the  necessity  of  calculating  the  amount 
in  detail. 

As  a  matter  of  general  practice  an  auditor  will  not 
care  to  take  advantage  of  this  opportunity  to  reduce  the 
liabilities,  as  there  are  possible  deductions  from  assets  which 
usually  more  than  offset  this  amount,  but  in  the  event  that 
the  greatest  exactness  is  required,  or  if  there  is  any  evi- 
dence of  a  desire  to  understate  the  net  werth  of  a  concern 
by  undervaluing  the  assets,  it  may  be  necessary  to  apply  the 
same  principles  to  the  liabilities.  Or  again,  a  concern  doing 
a  very  large  business,  such  as  a  department  store,  may  allow 
no  cash  discounts  to  customers  but  may  exact  them  from  its 
creditors.  In  such  a  case  the  adjustment  suggested  may 
make  a  material  change  in  the  balance  sheet. 

Consignments 

If  the  business  under  audit  is  one  where  there  is  any 
possibility  of  goods  having  been  received  on  consignment, 
and  part  or  all  of  such  goods  having  been  sold  without  a 
liability  therefor  having  been  created  in  the  books,  the  au- 
ditor must  use  all  due  diligence  to  cover  the  point  fully.  In- 
stances have  been  known  where  concerns  have  sold  and 
collected  for  consigned  goods  without  making  any  record 
of  the  liability  until  payment  is  made.     This  may  occur 


154 


AUDITING 


where  there  is  no  intention  to  deceive,  as  consignment  ac- 
counts are  usually  treated  as  memoranda  only. 

If  inquiry  develops  the  fact  that  goods  have  been  re- 
ceived on  consignment,  all  records  in  connection  therewith 
should  be  called  for.  If  the  goods  have  all  been  sold,  the 
consignor's  account  should  show  the  full  amount  due  and, 
if  the  debt  is  a  current  one,  the  amount  will  appear  among 
those  due  to  trade  creditors. 

If  it  appears  that  the  consigned  goods  are  partly  sold 
and  partly  on  hand,  a  memorandum  or  "pro  forma"  account 
sale  should  be  made  up  for  the  part  of  each  lot  disposed  of 
but  not  yet  accounted  for.  The  net  proceeds  due  to  the 
consignors  should  be  entered  as  a  liability  in  an  account 
called  "Accounts  Payable  Consignors."  As  some  time  may 
elapse  before  payment,  it  is  not  necessary  to  include  the 
aggregate  among  the  trade  creditors,  except  as  a  liability 
accrued,  but  not  due.  When  the  books  are  reopened,  the 
entries  for  uncompleted  consignments  should  be  reversed. 

Notes  Payable 

It  is  usual  and  desirable  to  divide  the  aggregate  of 
notes  payable  into : 

1.  Notes  issued  for  merchandise. 

2.  Notes  discounted  by  own  banks. 

3.  Notes  sold  through  brokers. 

4.  Demand  loans. 

And  a  further  separation  which  is  not  often  seen,  but  which 
is  most  desirable,  is  : 

1.  Notes  accompanied  by  collateral. 

2.  Notes  with  which  no  collateral  is  given. 

There  is  not  much  to  say  w4th  reference  to  the  proce- 
dure involved  in  verifying  the  existence  of  outstanding, 
unpaid  promissory  notes  except  to  warn  the  auditor  that 


BALANCE     SHEET    AUDIT— LIABILITIES  j-^ 

a  great  many  instances  have  been  known  where  outstanding 
notes  have  not  appeared  as  HabiHties  on  books  of  account. 

It  may  safely  be  said  that  if  deception  is  intended  so  far 
as  the  concealment  of  liabilities  is  concerned,  there  is  a 
greater  likelihood  of  its  existing  in  connection  with  notes 
payable  than  with  accounts  payable.  The  latter  are  usually 
evidenced  by  invoices,  and  any  attempt  to  hold  them  out 
would  attract  suspicion  on  the  part  of  the  office  staff.  With 
notes,  however,  it  is  comparatively  easy  to  secure  discounts, 
secrete  the  proceeds,  and  make  no  entry  therefor  on  the 
books  at  all.  This  omission  is  more  difficult  to  detect  in, 
and  probably  occurs  more  frequently  in  connection  with, 
single-entry  than  -with  double-entry  books. 

The  point  is  of  special  importance  where  audits  are 
made  for  the  benefit  of  prospective  lenders  of  money.  The 
borrower  tries  to  increase  his  assets  and  decrease  his  lia- 
bilities to  the  greatest  possible  extent.  He  also  may  at- 
tempt to  conceal  the  fact  that  he  has  issued  notes  and  may 
be  carrying  open  accounts  on  the  books,  while  in  reality 
notes  have  been  issued  therefor  which  are  falling  due  or 
which  are  overdue  and  unpaid. 

In  a  recent  bankruptcy  case  it  was  disclosed  that  a 
large  number  of  notes  had  been  given  to  creditors  without 
any  record  thereof  appearing  in  the  books.  The  notes  bore 
interest  and  several  creditors  had  secured  judgment  for 
non-payment.  As  the  interest  and  costs  amounted  to  a  con- 
siderable sum,  the  liabilities  were  increased  accordingly. 

A  more  dangerous  type  of  concealment  exists  wherein 
notes  are  issued  in  a  firm  or  corporate  name  for  money 
borrowed  by  individuals  and  which  pass  into  the  hands  of 
innocent  holders,  who,  of  course,  can  collect  if  a  concern  is 
solvent.  Notes  of  this  description  are  sometimes  renewed 
time  and  time  again  before  discovery.  An  auditor  who  ex- 
amines the  books  of  account   in  the  meantime  is  hardly 


156 


AUDITING 


likely  to  find  any  trace  thereof.  The  auditor  should  in  all 
cases  ask  each  bank  with  which  the  concern  under  audit  is, 
or  may  be,  doing  business  what,  if  any,  obligations  it  holds 
which  the  concern  may  have  to  pay. 

If  the  notes  are  discounted  by  one  of  the  regular  banks, 
it  would  seem  that  the  auditor,  as  well  as  the  office  staff, 
would  be  put  on  notice.  This  point  is  usually  covered  by 
a  statement  to  the  staff  that  the  discount  is  a  personal  loan 
to  a  partner  or  officer.  The  auditor  might  secure  a  clue, 
or  at  least  grounds  for  suspicion,  if  he  would  trace  back 
to  its  source  every  credit  of  cash  to  the  credit  of  a  partner 
or  officer  of  a  corporation.  As  a  matter  of  fact  so  many 
so-called  loans  of  this  nature  have  been  made  that  an  auditor 
may  with  propriety  ask  the  question  in  connection  with 
every  such  loan  :  ''Where  did  you  get  it  ?"  In  other  words, 
the  credits  to  the  individual  accounts  of  partners  or  officers 
might  represent  items  which  are  in  fact  liabilities  of  the 
firm  or  corporation. 

Mortgages 

As  a  mortgage  derives  its  chief  value  from  the  fact 
that  upon  registry  it  becomes  a  lien,  the  auditor  would 
seem  to  have  an  opportunity  to  verify  the  existence  of  such 
an  obligation  by  inspecting  the  public  records.  Auditors 
admit  the  value  of  the  knowledge  which  such  an  inspection 
discloses,  but  very  properly  urge  that  special  training  is 
necessary  to  undertake  the  task. 

It  is  admitted  by  all  that  a  well-equipped  auditor  must 
have  some  knowledge  of  law,  and  an  important  branch  of 
such  necessary  knowledge  is  that  pertaining  to  negotiable 
and  non-negotiable  instruments,  mortgages,  deeds,  con- 
tracts, etc.  The  author  suggests  that  a  reasonably  intelli- 
gent auditor  or  audit  clerk  can  ascertain  the  procedure  of 
the  public  registry  office  in  less  than  an  hour,  and  that  a 


BALANCE    SHEET    AUDIT— LIABILITIES 


157 


search  for  unsatisfied  mortgages  or  judgments  can  be  made 
in  less  time  than  it  takes  to  verify  the  footings  of  a  voucher 
register,  and  is  an  immeasurably  more  important  thing  to 
do.  If  the  auditor  is  timid  about  undertaking  the  job,  it 
might  be  worth  while  to  arrange  with  a  local  lawyer  or 
title  company  whereby,  for  a  small  fee,  any  mortgages  Or 
judgments  entered  against  his  clients  would  be  reported 
to  him. 

So  much  for  a  purely  independent  search.  If  the  au- 
ditor feels  justified  in  accepting  the  book  record  as  to  the 
existence  of  a  mortgage,  he  should  at  least  endeavor  to 
verify  the  amount,  the  rate,  the  due  date,  and  the  property 
secured  thereby.  All  of  these  points  are  of  interest  to  those 
who  may  desire  to  refer  to  the  balance  sheet  of  the  mort- 
gagor. 

It  should  be  borne  in  mind  that  a  payment  on  account 
of  a  mortgage  must  be  recorded  or  the  entire  amount  will 
remain  as  an  encumbrance  on  the  property.  Therefore,  if 
payments  on  account  appear,  the  auditor  should  ascertain 
if  the  principal  has  been  legally  reduced;  if  not,  the  fact 
should  appear  on  the  balance  sheet. 

Bonds 

So  many  different  classes  of  bonds  have  been  evolved 
by  the  fertile  brains  of  needy  financiers  that  no  attempt  will 
be  made  here  to  differentiate  except  in  a  general  way. 

Bonds  secured  by  a  mortgage  upon  real  estate  are,  of 
course,  the  most  popular  with  investors."  At  one  time  all 
bonds,  when  they  were  not  otherwise  designated,  were  sup- 
posed to  be  secured  by  real  property,  but  today  many  issues 
of  bonds  are  mere  promissory  notes,  differing  only  from  the 
usual  form  of  the  latter  in  that  they  are  larger,  have 
coupons  attached,  are  sealed,  and  are  also  less  valuable  be- 
cause they  do  not  fall  due  for  a  considerable  period.    From 


158  AUDITING 

the  auditor's  point  of  view  the  security  is  important  because 
of  its  bearing  on  other  obligations  and  the  equity,  if  any, 
which  may  exist  for  a  subsequent  lender  or  creditor. 

Balance  sheets  are,  as  a  rule,  deficient  in  the  information 
which  they  impart  with  reference  to  the  real  estate  or  per- 
sonal property  which  is  pledged  with  an  issue  of  bonds. 
Sometimes  a  bond  is  a  first  Hen  on  certain  assets  and  a  second 
lien  on  others.  When  considering  the  matter  of  liens  it 
should  be  noted  that  interest  unpaid  is  a  Hen  as  well  as 
unpaid  principal. 

^  If  it  is  feasible  to  have  a  balance  sheet  disclose  the  posi- 
tion which  a  bond  bears  to  the  assets,  it  is  the  auditor's  duty 
so  to  state  it.     In  any  event  he  should  determine  as  nearly 

^as  possible  the  position,  if  it  is  not  so  disclosed. 

-  The  corporation  which  issues  bonds  should,  and  in  most 
cases  does,  keep  a  copy  or  sample  thereof.  The  auditor 
should  read  this  carefully  in  connection  with  the  mortgage 

^or  deed  of  trust,  make  an  abstract  of  these  documents,  and 
note  all  references  to  interest  rate  (or  rates,  as  changes 
are  sometimes  made),  due  date  or  dates  (instalments  of 
principal  are  frequently  provided  for),  property  pledged, 
sinking  fund  or  similar  provisions,  and  in  fact  anything 
which  relates  to  the  accounts  or  financial  transactions  of  the 
maker. 

Judgments 

It  frequently  happens  that  a  prosperous  concern  will  dis- 
pute a  claim,  litigate  it,  and  have  judgment  entered  against 
it.  If  the  case  is  appealed  the  judgment  may  be  allowed 
to  stand  or  a  bond  may  be  given  pending  a  final  decision. 
In  rare  instances  are  these  debts  entered  on  the  books. 
Most  business  men  consider  that  the  entry  of  an  invoice  is 
an  admission  of  HabiHty,  and,  of  course,  wiU  not  permit  the 
entry  of  a  claim  which  they  propose  to  fight. 


BALANCE     SHEET    AUDIT— LIABILITIES  159 

What  position  must  the  auditor  take?  If  a  balance 
sheet  is  being  constructed,  the  amount  of  the  judgment 
should  be  included  as  a  liability  or  a  reserve  set  up  to  cover 
the  estimated  liability  under  the  claim.  If  a  balance  sheet 
has  been  completed,  the  auditor  should  call  attention  thereto 
in  a  footnote. 

How  is  the  auditor  to  be  informed  as  to  the  existence 
of  judgments?  As  mentioned  under  mortgages  (page  156), 
he  should  be  able  to  examine  the  public  record  himself.  If 
he  is  not  willing  to  do  this,  he  should  make  such  inquiry 
or  investigation  as  is  feasible.  An  inspection  of  lawyers' 
bills  is  a  good  way  to  secure  a  clue.  If  a  concern  is  able  to 
pay,  but  does  not  do  so  on  principle,  the  auditor  w^ill  have 
no  difficulty  in  learning  the  facts.  If  a  concern  is  obviously 
hard  up,  the  auditor  is  charged  with  constructive  knowledge 
that  judgments  have  been  obtained,  and  he  is  not  safe  unless 
he  secures  a  report  based  on  a  search.  Even  if  the  search 
costs  a  few  dollars  the  expense  will  be  well  worth  while.  If 
the  audit  is  made  for  a  banker,  the  latter  may  have  had  a 
search  made,  or,  if  not,  will  do  so  through  his  own  attorney. 

Interest  Payable 

Many  of  the  liabilities  which  appear  on  a  balance  sheet 
carry  interest,  therefore  the  calculation  of  accrued  interest 
to  the  date  of  the  balance  sheet  is  an  important  matter.  The 
auditor  should  consider  the  possibility  of  an  accrual  upon 
the  accounts  as  well  as  notes  payable,  bonds,  etc.  Enough 
book  accounts  bear  interest  to  warrant  an  inquiry  being 
made  into  its  possibility. 

Loan  accounts  of  partners  and  officers  of  corporations 
almost  invariably  bear  interest,  but  it  is  not  always  cal- 
culated up  to  the  date  of  closing  the  books.  Judgments, 
overdue  taxes,  and  other  liens,  bear  interest  sometimes  at 
an  extremely  high  rate. 


^6o  AUDITING 

Legally,  the  interest  on  a  bond  is  secured  by  the  same 
property  as  the  principal  and  in  effect  becomes  part  of  the 
principal,  but  the  latter  is  a  long-term  obligation,  while  in- 
terest is  payable  at  frequent  intervals  and  should  therefore 
appear  as  a  current  liability. 

Taxes 

The  balance  sheet  of  a  commercial  enterprise  not  owning 
real  estate  rarely  shows  a  liability  for  accrued  taxes,  yet 
probably  ninety-nine  out  of  every  one  hundred  are  liable 
therefor.  Under  the  Federal  Income  Tax  Law  a  tax  of  1 
per  cent  is  imposed  upon  the  net  profits  of  a  corporation. 
This  tax  must  be  paid  even  if  a  corporation  is  dissolved 
before  the  end  of  the  year  during  which  the  tax  is  imposed. 
As  the  tax  is  specifically  based  on  the  net  profits  of  a  par- 
ticular period,  although  payable  some  months  thereafter, 
/  the  tax  accrues  throughout  the  specified  period,  and  if  a 
-net  profit  is  disclosed  upon  the  closing  of  the  books,  a 
^reserve  of  1  per  cent  thereof  should  be  made. 

Bond  interest  which  accrues  from  July  1  to  December 
31,  and  which  is  payable  on  January  1,  always  appears 
among  the  liabilities  on  December  31,  assuming,  of  course, 
that  a  proper  system  of  accounts  is  in  force.  The  Federal 
tax  accrues  as  of  December  31,  or  at  the  end  of  its  fiscal 
year,  just  as  surely  as  any  other  item. 

The  uncertainty  as  to  the  constitutionality  of  the  law 
may  have  justified  the  omission  of  this  liability  from  balance 
sheets  prior  to  1911,  but  there  is  no  longer  any  doubt  about 
the  necessity  for  a  strict  compliance,  and  auditors  cannot 
certify  to  the  balance  sheet  of  a  prosperous  corporation 
which  has  not  given  proper  consideration  to  this  subject. 

A  corporation  which  had  made  a  large  temporary  profit 
was  dissolved  in  July.  A  balance  sheet  was  prepared  and 
on  its  showing,  a  distribution  of  capital  and  profits  was 


BALANCE    SHEET    AUDIT— LIABILITIES  i6i 

made.  In  the  following  February  the  government  de- 
manded a  report  and  1  per  cent  of  the  profit  realized.  One 
of  the  directors  had  to  pay  the  assessment. 

The  matter  of  taxes  is  of  particular  importance  in  all 
audits  of  public  service  corporations,  but  the  auditor  should 
consider  the  possible  liability  for  taxes  before  finally  passing 
upon  any  balance  sheet. 

Water  Rates,  etc. 

There  are  certain  expenses,  such  as  gas  and  water,  the 
bills  for  which  are  frequently  rendered  at  long  intervals. 
The  auditor  should  provide  for  all  accrued  expenses  of  this 
class. 

Wages 

The  date  of  the  balance  sheet  does  not  always  coincide 
with  the  date  to  which  a  pay-roll  has  been  calculated.  Un- 
less the  amount  is  trifling  the  amount  accrued  should  be 
ascertained  and  entered  as  a  liability. 

Where  there  is  little  fluctuation  in  the  number  of  men 
employed,  it  will  be  sufficient  to  take  the  proportion  of  the 
full  week's  pay-roll;  i.e.,  if  the  next  succeeding  pay-roll 
amounts  to  $1,000,  and  three  days  accrue  in  each  period, 
the  liability  can  be  stated  at  $500,  although  each  day's  total 
might  vary  a  few  dollars  from  the  others.  The  difference 
would  not  be  large  enough  to  pay  for  the  work  involved  in 
making  the  calculations. 

Rent 

Rent  is  usually  payable  in  advance,  but  this  is  not  always 
the  case.    If  any  is  accrued  and  not  paid,  it  should  be  shown. 

Freight 

Sales  are  frequently  made  on  a  basis  of  free  delivery 
to  destination,  and  current  freight  bills  are  sometimes  per- 
mitted to  run,  if  the  concern  is  well  known. 


l62  AUDITING 

An  allowance  of  freight  to  a  customer  should  be  treated 
as  a  deduction  from  amounts  due  from  trade  debtors. 

Goods  may  have  been  shipped,  refused,  and  returned, 
in  which  case  freight  charges  will  have  accrued. 

Traveling  Expenses  and  Commissions 

It  is   important   to   note  whether   the   accounts   of   all 

traveling  salesmen  have  been  received  and  entered  before 

the  books  are  closed.    The  auditor  should  secure  a  list  and, 

if  any  report  was  not  so  entered,  provision  therefor  should 

-be  made. 

Ample  provision  should  be  made  for  all  commissions 
eventually  payable  on  sales  which  have  been  billed  to  cus- 
tomers. As  commissions  are  frequently  not  payable  to 
salesmen  until  the  sales  have  been  collected  from  the  cus- 
tomers, accrued  commissions  are  often  omitted  from  the 
books.  As  they  must,  however,  be  paid  out  of  the  proceeds 
of  the  sales  on  which  the  full  profit  has  already  been  taken 
into  the  accounts,  they  should  clearly  be  set  up  as  a  lia- 
bility. 

Legal  Expenses 

All  concerns  have  more  or  less  litigation.  Lawyers  are 
usually  expensive,  but  they  have  the  merit,  if  it  can  be  so 
termed,  of  waiting  for  their  money.  Before  the  books  are 
closed  the  lawyers  should  be  requested  to  send  in  a  bill.  If 
one  is  not  found,  the  auditor  should  ascertain  the  amount 
due,  if  any. 

Audit  Fees 

In  line  with  the  theory  that  all  accrued  expenses  must 
be  included  among  the  liabilities,  it  might  be  assumed  that 
the  expense  incurred  for  an  audit  to,  say,  June  30,  would  be 
a  proper  charge  to  the  period  prior  thereto.  In  practice,  how- 


BALANCE    SHEET    AUDIT— LIABILITIES  163 

ever,  it  is  not  usual  to  include  the  audit  fee  as  an  outstand- 
ing liability  as  of  the  date  of  the  balance  sheet.  If  the  auditor 
has  not  performed  any  work  on  the  accounts  until  after  the 
closing  date,  it  is  certain  that  no  legal  liability  exists  at  that 
time. 

Under  ordinary  conditions  the  amount  of  the  fee  is  not 
known  until  after  the  report  is  written  and  submitted,  so 
that  no  more  than  an  estimate  could  be  included. 

Ordinarily  the  fee  is  not  such  a  liability  as  should  be  pro- 
vided for,  provided  that  the  audit  commences  after  the  clos- 
ing date.  An  exception  should  be  made,  however,  in  the  case 
of  a  partnership  or  a  close  corporation  where  a  partner  or 
stockholder  is  about  to  retire.  The  audit  being  partly  for  the 
benefit  of  the  retiring  party,  and  he  being  entitled  to  a  copy 
of  the  report,  it  is  proper  that  a  sufficient  reserve  should  be 
set  aside,  prior  to  the  closing  of  the  books,  to  provide  therefor. 

Damages 

It  is  customary  to  msure  against  liability  for  damages 
claimed  by  employees  or  the  public,  but  few  insurance  pol- 
icies, if  any,  assume  an  unlimited  liability.  Then  all  concerns 
do  not  carry  such  insurance,  although  it  is  a  reflection  on  a 
man's  business  ability  to  omit  such  protection.  Furthermore, 
claims  for  damages  may  arise  out  of  alleged  breach  of  con- 
tract, or  failure  to  deliver  goods,  or  for  any  one  of  many 
other  reasons.  _^ 

The  auditor  should  inquire  as  to  this  possible  liability  and 
should  also  request  that  a  letter  be  procured  from  the  con- 
cern's attorneys  stating  any  pending  claims  or  suits.  ^ 

It  may  be  that  claims  have  arisen  which  have  not  been 
referred  to  the  attorney.  It  often  happens  that  a  salesman 
claims  commissions  in  excess  of  those  paid  to  him,  or  an 
employee  who  has  been  dismissed  claims  salary  or  other 
compensation  for  an  uncompleted  term  of  service,  or  claim 


1 64  AUDITING 

is  made  for  a  part  of  profits,  which  has  not  been  paid.  It  is 
true  that  these  are  unusual  items,  but  it  is  equally  true  that 
tens  of  thousands  of  dollars  have  been  paid  out  in  liquid- 
ation of  disputed  claims. 

If  an  auditor  finds  any  evidence  which  leads  him  to  sus- 
pect that  there  may  be  a  possible  liability  of  this  nature,  he 
should  insist  on  being  informed  as  to  all  of  the  facts.  He  can 
then  form  an  opinion  as  to  the  reserve,  if  any,  which  should 
be  made  on  the  books  and  balance  sheet  to  provide  therefor. 

Coupons,  Unused  Tickets,  etc. 

The  auditor  of  a  railway  company  will  expect  to  (but 
may  not)  find  a  reserve  account  for  the  outstanding  liability 
in  respect  to  unused  tickets,  but  the  point  receives  little  or 
no  attention  in  other  cases.  Many  kinds  of  enterprises  sell 
tickets,  or  issue  coupons  at  a  discount  for  cash  which  are 
a  charge  on  the  subsequent  operation  of  the  business. 
Tickets  or  coupons  are  issued  by  taxicab  companies,  spring- 
water  dealers,  restaurants,  amusement  parks,  and  shows. 
Telephone  companies  formerly  issued  stamps  good  for  long- 
distance calls. 

Not  all  of  the  unused  tickets,  etc.,  will  be  presented,  but 
so  long  as  they  are  outstanding,  provision  must  be  made  for 
redemption.  The  auditor  will  not  attempt  to  verify  the  out- 
standing liability  in  detail,  but  he  should  carefully  examine 
the  system  followed,  because  if  the  proper  principles  are  ob- 
served, the  outstanding  book  liability  will  be  in  excess  of 
the  actual  redemption  which  may  be  expected.  Many  tickets, 
coupons,  etc.,  are  lost  or  destroyed,  and  it  is  obviously  im- 
possible to  issue  duplicates. 

Deposits 

Reference  is  not  made  to  the  deposits  received  by  banks, 
bankers^  and  saving  funds,  but  to  the  funds  which  are  de- 


BALANCE    SHEET    AUDIT— LIABILITIES  165 

posited  as  a  guarantee  of  good  faith,  or  as  part  payment 
on  a  purchase,  or  as  security  for  an  unUquidated  or  possible 
debt. 

If  the  concern  is  operating  under  a  pubHc  franchise,  as 
a  gas  or  electric  company,  it  may  have  the  power  to  require 
deposits,  and  in  many  instances  it  will  be  charged  with  the 
payment  of  interest  thereon.  Interest  is  not  usually  paid 
until  the  receipt  for  the  original  deposit  is  surrendered,  and 
this  may  be  many  years  afterward.  Large  numbers  of  the 
receipts  are  lost  or  destroyed  and  demand  is  never  made. 
Nevertheless,  the  company  should  carry  all  of  the  deposits 
as  a  liability  and  reserve  the  interest  accruing  thereon  until 
a  sufficient  time  has  elapsed  to  warrant  writing  off  such 
deposits  as  may  have  been  uncalled  for  so  long  that  the 
chances  of  payment  are  remote. 

The  custom  of  receiving  deposits  of  money  from  em- 
ployees is  well  enough  established  to  warrant. the  inclusion 
of  the  caption  "Deposits"  as  one  of  the  liabilities  to  be  re- 
ported by  prospective  borrowers  to  banks. 

The  auditor  should  investigate  the  procedure  followed 
from  the  time  a  deposit  is  accepted  to  the  time  it  is  with- 
drawn. There  should  be  ample  safeguards  surrounding  the 
handling  of  such  funds,  as  the  deposits  are  frequently 
offered  by  ignorant  persons  and  foreigners  who  are  not 
familiar  with  business  methods  and  who  might  be  induced 
to  accept  irregular  receipts  from  clerks  not  authorized  to 
handle  the  money.  It  is  important  that  the  books  and  sta- 
tionery used  should  be  specially  prepared'  for  the  purpose, 
and  the  utmost  care  should  be  taken  in  writing  up  the 
records.  The  clerk  in  charge  of  the  books  should  not  be 
allowed  to  receive  or  pay  money. 

If  pass-books  are  furnished  to  depositors,  the  auditor 
should  call  in  as  many  as  possible  and  compare  the  entries 
and  balances  with  the  books.    There  are  so  many  differpi!]: 


l66  AUDITING 

methods  in  force  that  the  auditor  must  rely  on  his  general 
experience  in  order  to  satisfy  himself  that  the  aggregate 
deposits  appearing  on  the  balance  sheet  as  a  liability  repre- 
sent the  actual  amount  due  to  depositors.  The  rate  of  in- 
terest paid  should  be  verified  and  the  calculations  tested. 
Accrued  interest  at  the  date  of  the  balance  sheet  not  credited 
to  depositors  should  be  added  to  the  total  deposits  shown 
by  the  books. 

For  various  methods  of  calculating  interest  see  Chapter    . 
XXII. 

In  clubs  and  similar  organizations  it  is  customary  for 
members  to  deposit  a  small  sum  as  security  against  the  loss 
of  keys,  etc.  To  avoid  bookke-eping  in  connection,  there- 
with, a  very  loose  method  may  be  in  force.  Frequently  the 
cash  received  is  placed  in  a  drawer  or  box  without  any 
record  being  made.  Subsequent  payments  are  likewise  made 
without  record.  Theoretically  the  balance  on  hand  repre- 
sents the  liability  for  outstanding  keys,  etc.  Practically  it 
is  known  that  part  of  the  cash  will  never  be  called  for.  This 
permits  unauthorized  payments  to  be  made  from  the  fund, 
or  part  may  be  fraudulently  abstracted.  The  matter  is 
unimportant  except  that  such  laxity  places  temptation  in 
the  way  of  junior  clerks  and  may  be  responsible  for  start- 
ing them  on  a  criminal  career. 

The  auditor  should  call  attention  to  the  importance  of 
a  careful  record  being  made  of  all  receipts  and  payments, 
no  matter  how  small,  primarily  for  the  purpose  of  facilitat- 
ing an  audit,  but  in  reality  to  inculcate  in  every  employee 
handling  cash  the  greatest  care  and  accuracy  in  connection 
with  the  handHng  of  money. 

Unclaimed  Dividends 

The  proper  way  of  dealing  with  dividend  accounts  is 
to  set  aside  in  a  separate  fund  or  bank  account  the  full  amount 


BALANCE    SHEET    AUDIT— LIABILITIES 


167 


of  each  dividend  declared,  charging  against  it  all  payments. 
It  sometimes  happens  that  stockholders  cannot  be 
reached,  and  dividend  checks  are  withheld  or,  if  issued,  are 
not  cashed  within  a  reasonable  time.  This  may  leave  an 
outstanding  liability  which  may  remain  undischarged  in- 
definitely. Where  such  a  state  of  affairs  exists,  any  pay- 
ments out  of  the  regular  order  should  be  noted,  as  it  may 
be  found  that  unauthorized  payments  are  being  charged 
thereto. 


CHAPTER  IX 

BALANCE    SHEET    AUDIT— LIABILITIES 
(Continued) 


CONTINGENT  LIABILITIES 

It  is  not  enough  that  a  balance  sheet  shows  what  must 
be  paid;  it  should  set  forth  with  as  much  particularity  as 
possible  what  may  have  to  be  paid.  More  than  one  appar- 
ently prosperous  business  house  and  many  corporations 
have  been  wrecked  through  the  necessity  of  having  to  meet 
obligations  which  did  not  arise  out  of  the  operation  of 
ordinary  business  transactions.  Nevertheless,  the  obliga- 
tions were  real  ones,  no  matter  how  unlikely  they  appeared 
to  be  when  contracted,  and  a  true  statement  of  the  financial 
affairs  of  such  concerns,  prepared  at  any  time  after  the 
obligations  had  beerk  entered  into,  would  have  set  them  out. 
Accountants  experienced  in  bankruptcy  affairs  well  know 
that  rarely,  if  ever,  do  contingent  liabilities  appear  on  the 
books  of  account. 

It  is  the  duty  of  an  auditor  who  makes  a  balance  sheet 
audit  to  discover  and  report  upon  liabilities  of  every  de- 
scription— not  only  liquidated  debts,  but  possible  debts.  It 
is  true  that  contingent  liabilities  are  at  best  difficult  to  locate, 
and  almost  impossible  of  discovery  when  an  attempt  is 
made  to  conceal  their  existence,  but  a  professional  auditor 
is  supposed  to  undertake  difficult  tasks,  and  if  he  cannot  re- 
port on  anything  except  the  entries  which  he  finds  in  the 
books^  he  had  better  retire  from  the  profession. 

i68 


BALANCE    SHEET    AUDIT— LIABILITIES 


169 


Notes  Receivable  Discounted 

As  shown  under  ''Notes  Receivable"  (page  80)  an 
apparent  asset  may  represent  an  actual  liability.  For  in- 
stance, a  trade  debtor  may  give  a  note  for  $1,000  which 
closes  his  account.  The  note  is  discounted,  which  closes 
the  notes  receivable  account.  The  debtor  finds  he  cannot 
pay  and  renews  the  note  when  due.  This  may  be  repeated 
several  times,  but  at  last  a  renewal  cannot  be  secured  and 
the  note  must  be  paid  by  the  indorser.  After  it  is  known 
that  the  note  will  not  be  paid  at  maturity  by  the  maker,  the 
liability  of  the  indorser  is  more  than  contingent — it  is 
actual. 

Of  course,  if  the  reserve  for  bad  debts  includes  a  pro- 
vision for  the  full  amount  of  the  note,  it  would  be  duplica- 
tion to  set  up  a  further  reserve  or  create  a  liability  against 
the  payment  of  the  note.  Usually  the  bad  debts  reserve 
is  not  large  enough  to  take  care  of  the  contingent  liability 
on  notes  discounted,  so  that  the  auditor  should  investigate 
the  status  of  all  notes  under  discount,  and  if  it  appears  prob- 
able that  any  w'ill  not  be  met  when  due,  the  liability  therefor 
should  be  shown.  In  cases  where  the  auditor  is  satisfied 
that  notes  will  neither  be  paid  nor  renewed  he  should  in- 
clude the  amounts  under  current  liabilities,  stating  the  date 
when  due. 

In  the  case  of  a  large  holding  company  it  was  reported 
after  receivership  proceedings  had  been  instituted,  that  while 
its  published  reports  showed  liabilities  of  several  millions 
of  dollars,  there  existed  additional  liabilities  aggregating  a 
much  larger  sum.  Nominally  these  liabilities  consisted  of 
indorsements  upon  the  promissory  notes  received  from 
customers,  and  therefore  constituted  a  contingent  liability 
only.  Actually  the  notes  were  of  the  holding  company's 
own  manufacture,  being  the  nominal  obligations  of  sub- 
sidiary corporations,  and,  as  to  the  greater  part,  not  repre- 


I70  AUDITING 

sented  by  assets.  In  other  words  they  were  notes  payable 
of  the  holding  company  without  off-setting  assets,  except 
as  to  a  small  percentage.  The  notes  were  for  odd  dollars 
and  cents,  presumably  so  drawn  to  carry  out  the  fiction  of 
being  genuine  receivables. 

Indorsements 

In  addition  to  the  contingent  liability  upon  notes  dis- 
counted for  the  benefit  of  the  indorser,  there  may  exist 
a  liability  based  on  indorsements  for  the  benefit  of  others, 
usually  known  as  accommodation  indorsements. 

It  is  not  proposed  to  discuss  this  subject  exhaustively, 
as  the  question  of  ultra  vires  at  once  arises,  but  from  a  prac- 
tical point  of  view  it  may  be  assumed  that  every  indorsement, 
whether  by  an  individual,  firm,  or  corporation,  may  become 
an  ultimate  actual  liability  of  the  indorser.  Promissory 
notes  are  negotiable  instruments,  and,  in  order  that  they 
may  circulate  freely,  an  innocent  purchaser  for  value,  with- 
out notice  of  a  lack  of  consideration  on  the  part  of  a  maker 
or  indorser,  may  sue  and  recover  from  any  or  all,  in  turn. 

The  assumption  that  the  maker  will  pay,  or  that  the  notes 
w^ill  not  be  used,  or  will  not  find  their  way  into  the  hands  of 
outsiders,  has  been  dissipated  in  so  many  thousands  of  cases 
that  the  auditor  who  fails  to  include  accommodation  indorse- 
ments as  liabilities  because  he  is  advised  that  there  is  no 
possibility  of  payment  being  demanded  is  assuming  a  risk 
for  which  there  is  no  professional,  legal,  or  moral  justifica- 
tion. 

It  is  possible  that  circumstances  may  exist  where  such 
indorsements  are  not  liabilities,  as  would  be  the  case  if  a 
note  were  overdue  and  the  holder  had  notice,  but  the  vital 
point  to  bear  in  mind  is  that  solvent,  straightforward  con- 
cerns do  not  as  a  rule  request  nor  secure  indorsements  un- 
less under  stress  of  necessity,  or  upon  the  payment  of  a 


BALANCE    SHEET    AUDIT— LIABILITIES  171 

consideration.  If  the  maker  of  the  note  is  ''hard  up,"  the 
indorser  should  expect  to  pay  (as  he  usually  is  obUged  to 
do).  If  consideration  has  passed,  the  indorser  is  still  likely 
to  have  to  pay,  but  having  received  compensation,  his 
statement  should  show  the  amount  thereof  among  the  lia- 
bilities to  indicate  the  risk  which  has  been  assumed.  The 
full  amount  of  the  note,  less  the  compensation  received,  is 
a  contingent  liability. 

Naturally  the  auditor  will  not  include  indorsements 
among  the  liabilities  on  the  balance  sheet  unless  he  gives 
due  consideration  to  the  possibility  of  an  asset  to  offset. 
The  offset  will  usually  consist  of  a  claim  against  the  maker 
or  prior  indorser  who  has  failed  to  meet  an  obligation, 
which  at  once  is  prima  facie  evidence  that  the  asset  is  not  in 
satisfactory  shape.  In  the  majority  of  cases  it  is  merely 
a  question  of  sizing  up  a  bad  debt. 

The  foregoing  remarks  apply  to  cases  where  the  auditor 
is  informed  or  readily  ascertains  that  indorsements  are  out- 
standing. We  have  now  to  consider  the  procedure  where 
no  such  information  is  volunteered,  nor  apparent  on  the 
records.  The  author  was  about  to  state  that  the  auditor  is 
justified  in  assuming  that  the  practice  does  not  exist,  in 
view  of  the  fact  that  the  great  bulk  of  concerns  have  a  strict 
rule  which  forbids  indorsements  or  guarantees,  and  that 
there  must  be  special  cause  for  suspicion  before  special  in- 
quiry need  be  made,  but  reflection  brings  to  his  mind  so 
many  instances  of  contingent  liabilities  of  this  nature  that 
the  suggestion  is  made  that  all  audit  programs  contain 
some  reference  thereto. 

The  financial  ''atmosphere"  of  a  concern  is  a  fairly  de- 
pendable index  as  to  possible  obligations  or  entanglements 
which  may  find  expression  in  commitments  leading  to  future 
embarrassment  The  most  common  cause  is  overextension  of 
business  affairs,  and  this  is  more  likely  to  occur  with  a  pros- 


1^2  AUDITING 

perous  man  than  with  an  impecunious  one.  The  latter  has 
little  opportunity  for  expansion,  while  the  former  is  fairly 
besieged  by  promoters  and  others  who  know  by  long  ex- 
perience that  the  most  likely  investor  in  a  new  and  untried 
enterprise  is  a  man  who  knows  nothing  at  all  about  it.  All 
over  the  country  men  who  have  made  fortunes  in  their  own 
businesses  are  squandering  their  capital  in  outside  ventures. 

If  an  auditor's  report  went  no  further  than  his  client's 
office  it  would  not  be  necessary  for  him  to  concern  himself 
with  the  relation  of  outside  ventures  to  the  balance  sheet  of 
the  business  under  audit,  but  now  that  banks  are  demanding 
certified  balance  sheets,  the  auditor  must  always  proceed  on 
the  assumption  that  the  balance  sheet  prepared  by  him  will 
go  into  general  circulation.  The  auditor  who  is  observant, 
therefore,  will  be  able  to  determine  by  what  he  sees  in  an 
office  what  has  probably  taken  place  outside. 

If  a  partner,  or  officer,  has  withdrawn  considerable 
sums  of  money  for  investment  in  outside  enterprises,  there 
will  probably  be  some  reference  thereto  in  the  books.  Many 
corporations  are  partnerships  under  another  form  of  or- 
ganization, and  the  officers,  who  are  usually  identical  with 
the  large  stockholders,  keep  personal  accounts  in  the  cor- 
poration books.  The  charges  to  these  accounts  will  indicate, 
in  some  degree,  the  interests  in  outside  affairs. 

Let  us  consider  the  usual  effect  on  the  finances  of  a 
firm  or  corporation  where  its  owners  are  connected  with 
other  enterprises.  The  firm  or  corporation  may  have  good 
assets  of  $200,000  and  total  liabilities  of  $100,000.  Sup- 
pose one  or  more  of  the  partners  or  officers  become  inter- 
ested in  another  business  or  in  a  flotation  of  doubtful  merit. 
It  may  be  urged  that  so  long  as  the  balance  sheet  of  the 
firm  or  corporation  is  true  and  reflects  its  actual  financial 
condition,  the  action  of  its  partners  or  officers  cannot  affect 
it.     But  soon  the  outside  venture  requires  more  cash  than 


BALANCE    SHEET    AUDIT— UABILITIES  173 

can  be  supplied,  so  the  partner  or  officer  gives  his  note  for 
$25,000,  which  is  discounted.  The  auditor  comes  in  at 
this  point,  discovers  the  interest  in  the  outside  deal,  makes 
inquiry,  and  is  informed  as  to  the  note.  He  finds  further 
that  there  is  not  the  slightest  prospect  of  the  note  being 
met  by  the  outside  business. 

Is  it  not  apparent  that  the  cash  account  of  the  firm  or 
corporation  will  be  called  on  to  meet  that  note?  This  has 
happened  in  thousands  of  actual  cases;  is  it  not  likely  to 
happen  every  time?  Should  the  auditor  state  the  assets 
as  $200,000,  the  liabiHties  at  $100,000,  and  a  contingent 
liability  of  $25,000  ?  Legally,  no,  but  if  he  can  find  a  way 
to  do  it,  he  should  not  hesitate.  Banks,  creditors,  and  in- 
vestors would  have  saved  millions  of  dollars  in  the  past  if 
auditors  had  so  stated  the  affairs  of  corporations.  Is  it 
not  possible  to  protect  the  innocent  investor  or  creditor  when 
facts  of  this  nature  are  disclosed,  and  where  a  reasonable 
interpretation  makes  them  relevant? 

If  there  is  nothing  in  the  books  to  indicate  any  con- 
nection on  the  part  of  the  concern  itself,  a  partner  or  an 
officer,  with  outside  ventures,  and  there  is  no  apparent  reason 
for  suspecting  any  possible  indorsement  of  another's  paper, 
the  auditor  may  not  feel  it  necessary  to  carry  his  inquiries 
further.  In  fact,  it  might  be  impracticable  even  if  it  were 
desirable.  Nevertheless,  it  must  always  be  borne  in  mind 
that  the  indorsement  of  notes  for  outside  ventures  has  re- 
sulted disastrously,  and  in  cases  where  it  was  least  ex- 
pected; consequently  it  is  a  possibility  of  importance. 

Guarantees 

Almost  all  of  the  remarks  under  indorsements  apply 
with  equal  force  to  guarantees.  In  one  case  the  liability  is 
fixed  and  definite  by  reason  of  the  indorsements  of  nego- 
tiable paper,  whereas  a  guarantee  may  be  less  definite  so  far 


174  AUDITING 

as  legal  liability  is  concerned,  and  the  amount  of  the  obliga- 
tion may  be  uncertain.  Otherwise  there  is  the  same  likeli- 
hood of  being  required  to  pay  ultimately,  and  if  the  guar- 
antee covers  an  obligation  incurred  in  connection  with  an 
outside  venture,  there  also  exists  a  strong  probability  that 
the  funds  necessary  to  discharge  the  obligation  will  be 
withdrawn  from  the  concern  under  audit. 

The  proprietor  of  a  successful  business  reported  to  the 
mercantile  agencies  a  net  worth  of  about  one  million  dol- 
lars. His  statement  indicated  that  his  assets  were  not 
readily  realizable,  but  his  reported  liabilities  were,  small  and 
his  credit  was  rated  first  class.  He  was  induced  to  invest 
in  the  stock  of  a  distillery  and  was  elected  a  director.  The 
distillery  needed  money  and  he  was  induced  to  indorse 
some  of  its  paper  and  guarantee  other  loans. 

The  president  of  the  distiUing  company  was  found  to  be 
an  embezzler  to  a  large  extent,  and  the  company  went  into 
bankruptcy.  The  indorser  and  guarantor  was  called  upon 
to  meet  obligations  aggregating  over  one  hundred  thousand 
dollars,  and  he  was  unable  to  pay  all  of  his  debts  as  they 
became  due.  He  is  still  struggling  and  may  eventually  pay 
in  full,  but  it  has  meant  the  ruin  of  his  own  business. 

If  the  auditor  had  stated  the  accounts  of  the  guarantor's 
business,  it  is  not  likely  that  any  mention  would  have  been 
made  of  the  outside  liabilities,  as  the  business  was  incor- 
porated and  the  indorsements  would  have  been  ultra  vires 
for  the  corporation.  But  when  the  notes  came  due  and  the 
guarantor  started  to  pay,  the  only  funds  available  were  the 
resources  of  his  own  company,  and  these  funds  were  used. 
Therefore  his  balance  sheet  to  the  agencies  was  misleading, 
because  there  were  contingent  liabilities  affecting  it  in  fact 
if  not  in  law. 

An  auditor  could  have  readily  ascertained  the  existence 
of   the   directorship,    and   inquiry   no   doubt   would   have 


BALANCE     SHEET    AUDIT— LIABILITIES 


175 


brought  to  light  the  indorsements  and  guarantees.  If  so, 
would  he  have  been  justified  in  mentioning  the  matter  on 
the  balance  sheet?  The  author  is  of  opinion  that  it  would 
have  been  desirable  for  him  to  do  so.  Whether  or  not  it 
would  have  been  his  clear  duty  could  have  been  determined 
only  in  connection  with  the  circumstances  of  his  employ- 
ment. In  a  serious  matter  of  this  nature  an  auditor  should 
consult  his  attorney  before  disclosing  damaging  informa- 
tion, as  it  is  possible  that  the  scope  of  his  employment  might 
be  limited  and  that  his  only  course  would  be  to  withdraw 
from  the  engagement. 

Acceptances 

An  acceptance  is  a  draft  or  bill  of  exchange,  across  the 
face  of  which  are  written  the  word?  "accepted"  and  the  date 
thereof,  and  "payable"  and  the  date  thereof,  after  which 
appears  the  signature  of  the  payee.  Where  the  acceptor  is 
not  a  bank  or  banker  the  name  of  the  bank  or  the  place  at 
which  the  acceptance  is  payable  is  also  inserted. 

Heretofore  the  use  of  acceptances  in  this  country  has 
been  greatly  restricted,  although  abroad  they  are  in  general 
use.  Since  the  Federal  Reserve  Act  authorized  member 
banks  to  accept  bills  involving  the  exportation  or  importa- 
tion of  goods,  interest  in  and  the  use  of  acceptances  has 
greatly  increased.  In  the  state  of  New  York,  state  banks 
and  trust  companies  are  permitted  to  accept  drafts  drawn 
upon  them  by  their  customers  at  sight,  or  on  time  not  ex- 
ceeding one  year.  This  power  extends  to  both  foreign  and 
domestic  trade. 

As  financing  by  acceptances  becomes  more  popular  the 
auditor  will  be  prepared  to  advise  as  to  the  proper  treat- 
ment of  the  liability  arising  out  of  their  issuance  or  accept- 
ance. 

A  concern  drawing  a  draft  on  a  customer,  which  is  ac- 


176  AUDITING 

cepted  by  a  bank  or  banker,  can  immediately  discount  it 
at  its  own  bank  or  sell  it  in  the  open  market,  usually  at  a 
rate  considerably  under  the  discount  rate  for  commercial 
paper.  From  the  point  of  view  of  the  drawer  the  trans- 
action is  then  closed  and  no  mention  need  be  made  thereof 
on  its  balance  sheet.  Of  course  this  rule  applies  only  where 
the  accepting  bank  or  banker  Is  of  unquestioned  standing. 
If  the  drawee  does  not  have  national  standing,  consideration 
must  be  given  to  the  contingent  liability  existing  until  the 
draft  is  paid  by  the  acceptor  or  customer.  The  transaction, 
therefore,  is  of  the  nature  of  a  customer's  promissory  note 
discounted  at  bank,  and  the  book  entries  are  the  same,  except 
that  notes  not  paid  at  maturity  must  be  kept  track  of  and 
preparation  made  to  meet  them,  w^iereas  the  accepting  bank, 
in  the  case  of  an  acceptance,  is  responsible  for  the  payment. 

It  is  the  relation  between  the  bank  and  the  concern  for 
which  it  is  accepting  that  will  require  vigilance  on  the  part 
of  the  auditor.  The  Issuance  of  promissory  notes  and  the 
liability  for  the  payment  thereof  is  fully  covered  elsewhere 
in  this  book.*  Consideration  must  now  be  given  to  the 
possibility  of  an  outstanding  liability  existing  in  respect 
of  acceptances  not  recorded  upon  the  books. 

Would  it  be  possible,  however,  for  a  concern  to  pur- 
chase goods,  arrange  that  a  bank  accept  the  vendor's 
draft,  receive  and  put  the  goods  in  stock,  and  make  no 
record  of  the  existing  liability  until  the  due  date  arrives? 

So  many  instances  are  known  where  goods  were 
received  and  the  invoices  were  not  duly  recorded  that 
equal  attention  must  be  given  to  this  possibility  where 
acceptances  are  concerned.  The  usual  comparison  of 
order  and  receiving  records  with  purchase  invoices  should 
disclose  any  discrepancies  arising  out  of  carelessness.  It 
is  not  likely,  however,  that  the  further  safeguard  of  com- 


•See  p^e  155. 


BALANCE    SHEET    AUDIT— U  ABILITIES  177 

paring  creditors'  statements  with  corresponding  ledger 
accounts  will  be  feasible,  because  an  acceptance  usually 
covers  specific  invoices,  and  it  is  not  likely  that  the  cred- 
itor will  send  any  other  memorandum  thereof.  Banks 
make  a  charge  for  services  in  accepting  drafts,  and  pay- 
ments of  these  charges  should  be  vouched  in  connection 
with  the  acceptances  recorded." 

The  audit  of  a  bank  or  banker  will  necessarily  involve 
consideration  of  the  contingent  liabiHty  which  exists  so 
long  as  funds  are  not  provided  to  meet  at  maturity  the 
acceptances  which  are  outstanding.  Here,  too,  there  is 
a  direct  relation  between  the  charges  for  accepting  and  the 
acceptances  matured  and  unmatured.  The  best  method 
of  exhibiting  the  liabiHty  on  the  books  of  the  bank  or 
banker  is  to  debit  the  customer  for  whom  the  indorse- 
ment is  made  and  credit  bills  payable.  As  the  dates  of 
maturities  arrive  it  is  expected  that  funds  will  be  received 
to  meet  the  payments  due,  thus  closing  the  customer's 
account;  and  the  payment  of  the  acceptances  as  pre- 
sented in  due  course  will  close  the  bills  payable  account. 

Where  there  is  any  likeHhood  of  acceptances  being 
outstanding,  the  auditor  should  ask  the  bank  or  banks 
connected  with  the  concern  under  audit  to  confirm  the 
existence  or  non-existence  of  such  possible  liability. 

Constructive  service  can  be  rendered  by  auditors  who 
will  point  out  to  their  clients  the  advantages  of  a  greater 
use  of  domestic  acceptances.  Concerns  which  are  not  ade- 
quately financed  frequently  borrow  money  on  their 
accounts  receivable,  although  the  practice  is  not  favorably 
looked  upon  by  bankers  and  credit  men.  The  cost  of 
capital  so  secured  is  at  least  double  the  usual  rate  charged 
on  bank  discounts.  If  purchasers  will  agree  to  accept 
drafts  drawn  upon  them,  covering  specific  invoices,  pay- 
able on  the  due  dates  thereof,  there  will  be  available  to 


178 


AUDITING 


the  sellers  negotiable  paper  which  can  be  discounted  at 
a  favorable  rate.  It  will  be  a  material  advantage  and  sav- 
ing to  the  seller  and  will  involve  the  purchaser  in  no  more 
annoyance  than  is  necessary  in  drawing  and  sending 
cheques  tmder  the  present  system. 

The  Federal  Reserve  Board  strongly  encourages  this 
custom,  and  it  may  be  expected  that  suitable  legislation 
will  be  enacted  from  time  to  time  which  will  make  it  even 
more  desirable  than  now  appears.  Concerns  which  take 
the  lead  in  substituting  the  new  for  the  old  practice  can 
reasonably  count  upon  an  increase  in  their  prestige,  at 
least  among  bankers,  and  this  is  of  no  inconsiderable 
importance. 

Unfulfilled  Contracts 

It  has  been  mentioned  that  liabilities  not  on  the  books, 
in  the  form  of  contracts  to  accept  delivery  of  goods  con- 
tracted for  before  the  date  of  the  balance  sheet,  may  call 
for  the  payment  of  large  sums  of  money  within  a  short 
space  of  time.  It  may  be  urged  that  on  the  face  of  this 
statement  there  would  be  no  change  in  the  net  result 
shown  by  the  balance  sheet,  as  an  asset  would  be  received 
to  offset  the  liability. 

A  banker,  however,  might  look  upon  this  condition  in 
a  far  different  light.  The  balance  sheet,  for  instance, 
might  show  stock  on  hand  large  enough  or  too  large  for 
the  normal  requirements  of  the  business,  and  any  unful- 
filled contracts  outstanding  at  balance  sheet  time  which 
called  for  the  receipt  of  additional  stock,  which  might  not 
be  readily  salable,  would  mean  an  actual  liability,  whereas 
the  offset  would  be  an  asset  of  doubtful  value. 

In  every  audit,  therefore,  the  auditor  should  call  for 
copies  of  all  orders  for  future  delivery,  and  if  such  orders 
call  for  stock  in  excess  of  the  current  and  reasonable  pros- 


BALANCE    SHEET    AUDIT— LIABILITIES  179 

pective  demand,  mention  thereof  should  be  made  in  the 
balance  sheet.  The  details  reported  would  depend  on  the 
circumstances  of  each  particular  case. 

The  Minute  Book 

Experience  has  demonstrated  to  auditors  that  the  ex- 
ariiination  of  the  minute  book  is  a  most  prolific  source  of 
information  relative  to  contingent  liabilities. 

Recently  one  of  the  largest  corporations  in  this  coun- 
try issued  its  annual  report.  Included  therein  was  the 
auditor's  certificate,  which  said  in  effect:  *'The  balance 
sheet  is  correct,  subject  to  any  adjustments  which  might 
have  been  indicated  by  the  minute  books,  which  we  were 
requested  not  to  read."    What  did  this  mean? 

If  the  minute  books  contained  evidences  of  liabilities 
or  changes  in  assets,  as  might  be  inferred  from  the  re- 
fusal to  submit  same  to  the  auditors,  how  much  depend- 
ence could  the  directors  expect  to  have  placed  upon  their 
report  by  the  stockholders  and  the  public?  On  the  other 
hand,  if  the  contents  of  the  minute  book  were  harmless, 
why  should  the  auditors  be  refused  access  thereto  and 
thus  give  rise  to  unfavorable  comment  ? 

The  auditor  should  always  insist  on  an  inspection  of 
the  minutes  of  a  board  of  directors,  and  of  the  executive 
or  any  other  committee  of  the  board.  If  permission  is 
withheld,  his  certificate  should  be  written  along  lines  in- 
dicated above,  except  that  the  refusal  would  be  notice  to 
the  auditor  that  special  care  should  be  taken  in  passing 
upon  balance  sheet  items  which  might  be  affected  by  the 
action  of  a  board  of  directors. 

The  following  points  might  be  involved:  contracts  for 
additions  to  or  for  additional  plant  equipment;  purchase 
of  other  corporations  or  large  interests  therein;  contracts 
for  future  deliveries  of  goods  and  materials  in  unusual 


l8o  AUDITING 

quantities;  payments  of  bonuses  and  special  compensation 
to  officers  and  others  out  of  past  profits,  but  actual  pay- 
ment to  be  made  at  a  future  date;  settlement  of  pending 
litigation  for  a  sum  in  excess  of  the  liability,  if  any,  carried 
therefor  in  the  books;  possibility  of  litigation  such  as 
alleged  infringement  of  patents,  which  might  seriously 
affect  the  value  of  assets;  contracts  or  agreements  which 
might  tend  to  increase  the  assets  or  reduce  the  liabilities. 
These  are  only  a  few  of  the  matters  which  the  reading  of 
corporate  minutes  reveals  to  the  auditor. 

Usually  the  disposition  is  to  conceal  from  an  auditor 
evidence  of  contingent  liabilities,  the  thought  being  that 
he  might  feel  it  his  duty  to  provide  therefor  in  the  balance 
sheet.  Less  frequently  good  news  is  withheld  in  order 
that  the  balance  sheet  may  show  up  as  badly  as  possible 
and  thus  give  the  directors  time  to  acquire  stock  below 
its  value. 

The  author  once  insisted  on  reading  the  minute  book 
of  a  street  railway  company.  The  president's  reluctance 
to  produce  the  book  was  explained  when  it  was  found 
that  at  a  meeting  attended  by  the  president  he  agreed  to 
accept  common  stock  of  the  company  at  par  for  his 
services.  He  had,  however,  directed  the  treasurer  to  pay 
it  in  cash.  As  the  stock  was  worth  only  a  few  dollars 
a  share,  his  disinclination  to  carry  out  his  agreement  was 
natural,  perhaps,  but  illegal  and  dishonest.  He  was 
obliged  to  adjust  the  matter. 

If  an  officer  of  a  corporation  is  found  to  be  interested 
as  a  partner  or  otherwise  in  an  outside  enterprise  with 
which  the  corporation  has  business  relations,  the  connec- 
tion should  be  specifically  noted  and  authorized  by  the 
board  of  directors.  It  may  seem  to  be  a  matter  some- 
what beyond  the  directors'  scope,  but  aside  from  its  legal 
effect,   the   directors   should   be  required   to   take   some 


BALANCE    SHEET    AUDIT— LIABILITIES  igi 

formal  action  in  view  of  possible  subsequent  criticism, 
The  officer,  for  his  own  protection,  should  welcome  such 
a  course,  and  if  he  does  not,  the  auditor  should  himself 
bring  the  matter  to  the  attention  of  the  board. 

The  author,  in  auditing  the  accounts  of  a  chain  store 
company,  found  that  the  treasurer  of  the  company  was 
interested  in  a  concern  supplying  the  fixtures  to  the  vari- 
ous stores  owned.  The  price  of  the  fixtures  seemed  to  be 
extremely  high,  the  chain  store  company  was  unsuccessful 
to  a  marked  degree,  and  the  coincidence  seemed  impor- 
tant enough  to  warrant  mentioning  in  the  report.  The 
directors,  however,  sustained  the  treasurer  and  removed 
the  auditor.  As  the  board  had  theretofore  authorized  the 
capitalization  of  a  lease  and  the  writing  up  of  another 
item  equally  reprehensible,  crediting  both  fictitious  items 
to  surplus  and  using  the  entire  surplus  for  dividends,  the 
auditor  being  on  record  as  to  all  of  the  questionable 
transactions,  cheerfully  retired  without  any  effort  to  de- 
fend his  position.  Two  years  later  the  company  went  into 
bankruptcy. 

In  a  New  Jersey  receivership  proceeding  it  was  devel- 
oped that  the  minutes  of  the  board  of  directors  contained 
much  information  relative  to  finances  and  operations 
which  had  not  been  disclosed  to  the  stockholders  in  the 
annual  statement.  The  company  had  not  employed  pro- 
fessional auditors.  This  illustration  appears  here  merely 
as  an  indication  of  the  importance  of  the  examination  of 
the  minute  book. 

RESERVES 

The  matter  of  reserve  accounts  is  in  an  unsatisfactory 
condition  from  the  point  of  view  of  a  professional  auditor 
chiefly  because  the  term  is  indiscriminately  applied  to 
items  which  are  essentially  different.  For  instance,  an 
inspection  of  balance  sheets  will  disclose  that  the  follow- 


l82  AUDITING 

ing  accounts  are  called  ''Reserves":  provision  for  probable 
losses  in  respect  to  accounts  or  notes  receivable;  accounts 
set  up  to  cover  depreciation  of  plant  and  other  assets  such 
as  patents,  trade-marks,  etc.;  discounts  which  it  is  ex- 
pected will  be  deducted  by  trade  debtors;  arbitrary 
charges  against  surplus  to  provide  a  book  account  for 
"working  capital";  sinking  fund  accounts  to  take  care  of 
depletion  of  mines,  or  to  retire  bonds  at  maturity. 

It  will  be  noted  that  some  of  the  so-called  reserves  are 
actual  deductions  from  assets  and  should  be  so  treated, 
thus  having  the  effect  of  liabilities,  while  others  are  not 
liabiHties  at  all.  The  distinction  lies  in  the  creation  of  the 
accounts.  If  the  debit  or  offsetting  entries  are  proper 
charges  against  income,  then  the  accounts  should  be  de- 
ducted from  the  assets  to  which  they  relate,  or  else  they 
should  be  set  up  as  liabilities  and  should  never  be  grouped 
with  the  surplus  account.  On  the  other  hand,  if  the  ac- 
counts represent  sums  set  aside  after  the  net  profit  of  an 
enterprise  is  determined  upon  a  proper  accounting  basis, 
for  the  purpose  of  conserving  its  financial  interests  by 
reducing  the  surplus  available  for  dividends,  and  thus  in 
reality  form  part  of  the  general  surplus  of  the  business, 
then  the  accounts  should  be  stated  as  a  section  of  the 
surplus  account. 

This  line  of  reasoning  may  be  tested  by  setting  up  on 
one  side  the  assets  at  what  the  auditor  believes  to  be  a 
fair  net  valuation;  from  the  total  so  ascertained,  the  lia- 
bilities, actual  and  contingent,  should  be  deducted;  the 
balance  will  represent  what  may  be  termed  the  net  worth 
of  the  business.  If  a  corporation,  the  capital  stock  may 
now  be  considered,  leaving  the  balance,  if  any,  to  represent 
surplus. 

It  cannot  be  maintained  that  a  sum  set  aside  to  pro- 
vide  additional   working   capital   could   be   treated   as.  a, 


BALANCE     SHEET    AUDIT— LI  ABILITIES 


183 


liability  in  any  sense  of  the  word.  To  whom  is  it  to  be 
paid?  A  liability,  from  a  balance  sheet  point  of  view,  is 
an  obligation  or  a  debt  to  the  public,  i.e.,  something 
which  must  or  may  have  to  be  paid  before  partners  or 
stockholders  can  receive  a  dividend  or  a  distribution. 

In  actual  practice  reserves  are  usually  shown  between 
the  definite  liabilities  and  the  surplus,  but  wherever  it  is 
possible  to  state  actual  assets  and  actual  liabilities  apart 
from  capital,  surplus,  and  surplus  reserves,  it  should  be 
done.  Some  reserves  represent  unliquidated  liabilities  to 
the  pubHc,  but  others,  such  as  depreciation  reserves,  are, 
strictly  speaking,  direct  deductions  from  assets  and  are 
not  liabilities. 

If  a  necessity  seems  to  exist  for  stating  the  gross 
amount  of  the  assets  on  one  side  and  the  reserves  against 
such  assets  on  the  other,  then  the  reserves  must  be  in- 
cluded among  the  liabilities  in  order  that  the  aggregate 
of  one  side  may  be  deducted  from  the  other  so  as  to 
determine  net  worth.  This  procedure  must  not  be  con- 
fused with  the  criticism  which  is  applied  to  the  balance 
sheet  form  which  shows  on  one  side  or  the  other,  items 
which  are  not  assets  nor  liabilities  nor  deductions  from 
either  class.  Any  amount  which  directly  relates  to  an 
actual  asset  or  liabiHty  may  be  grouped  therewith  without 
violating  the  rule  against  the  misuse  of  these  two  terms. 

The  author's  test,  therefore,  is  that  a  reserve  account, 
to  properly  appear  among  the  liabilities  on  a  balance  sheet, 
must  represent: 

1.  Estimated  amounts  which  are  believed  to  have  ac- 

crued and  which,  when  determined,  will  be  actual 
liabilities. 

2.  Items  which  are  deductible  from  assets  to  reduce 

the  latter  to  their  true  value. 

3.  Contingent  liabilities, 


1 84 


AUDITING 


4.  "Reserve"  of  an  insurance  company. 
Under  these  will  appear: 

1.  Accruals  such  as  interest,  wages,  taxes,  etc. 

2.  Depreciation  and  obsolescence  of  plant,  exhaustion 
of  mines,  estimated  loss  on  accounts  receivable,  etc. 

3.  Provision  for  the  contingencies  discussed  in  these 
pages,  but  the  reserve  should  be  based  on  evidence  more 
tangible  than  a  mere  desire  to  be  conservative.  A  vague 
feeling  that  something  might  have  been  overlooked  which 
would  decrease  the  assets  or  increase  the  liabilities  is  not 
the  proper  subject  for  a  reserve.  Conservative  manage- 
ment "reserves"  part  of  its  surplus  for  such  contingencies, 
but  it  appears  as  surplus  and  not  as  a  liability. 

4.  The  reserve  of  an  insurance  company  is  usually  an 
actual  liability,  i.e.,  income  has  been  received  and  treated 
as  income,  whereas  part  only  has  been  earned,  as  in  the 
case  of  fire  insurance  and  similar  companies  where 
premiums  are  paid  in  advance,  and  the  unearned  portion 
should  be  carried  as  a  liability.  Theoretically,  the  aggre- 
gate of  this  unearned  income  forms  a  reserve  for  rein- 
surance, the  theory  being  that  if  a  company  desired  to 
suspend  business,  it  could  reinsure  all  of  its  risks  out  of 
the  reserve  and  leave  its  capital  and  surplus  intact.  Like- 
wise, life  insurance  companies  not  only  collect  premiums 
in  advance,  but  they  also  collect  more  than  is  sufficient 
to  pay  for  the  insurance  carried.  The  excess  is  returnable 
to  the  assured  under  the  contract,  and  is  therefore  a  lia- 
bility rather  than  part  of  the  accumulated  surplus  of  the 
company.  Under  some  policies  the  excess  is  rebated  an- 
nually, under  others  no  distribution  is  made  until  the 
policy  expires.  From  an  accounting  point  of  view  a 
mutual  insurance  company  would  have  no  surplus,  because 
as  it  agrees  to  insure  at  cost,  all  excess  premiums  received 
are  the  property  of  the  assured.    Of  course  a  life  insurance 


BALANCE     SHEET    AUDIT— LIABILITIES 


I8S 


company  should  be  conservative  to  the  last  degree,  and 
it  may  be  that  it  would  not  be  safe  to  allocate  all  of  the 
estimated  excess  income  to  specific  policy  holders. 

All  of  the  classes  of  reserves  just  enumerated  have 
been  or  will  be  fully  discussed  under  their  respective  heads. 
The  so-called  reserves  which  are  not  charges  against  in- 
come, but  which  are  set  aside  after  net  profits  are  deter- 
mined, and  which  therefore  are  in  reality  divisions  of 
surplus  account,  will  be  discussed  under  the  general  title 
of  ''Surplus." 

PARTNERSHIPS 

Partnership  Agreements 

Corresponding  to  the  minute  book  of  a  corporation 
is  the  written  agreement  of  copartnership,  and  the  auditor 
should  not  certify  to  the  balance  sheet  nor  profit  and  loss 
statement  of  a  partnership  without  reading  the  agreement. 
As  with  the  board  minutes,  it  may  disclose  important 
matters  relating  to  the  finances  and  accounts,  a  true  re- 
flection of  which  should  be  found  in  the  balance  sheet. 

In  audits  of  firms,  the  rights  and  liabiHties  of  each 
partner  must  be  considered.  Usually  one  partner  names 
or  retains  the  auditor,  and  in  many  cases  assumes  an  em- 
barrassing proprietary  interest  over  him.  Nevertheless, 
the  auditor  must  maintain  the  strictest  neutraUty,  for 
partnerships  too  often  end  in  litigation,  and  the  auditor 
who  has  shown  any  signs  of  favoritism  may  find  himself  in 
an  unpleasant  position. 

Where  there  is  no  partnership  agreement  or  where  it 
is  deficient  in  terms,  the  following  guide  may  be  profitably 
consulted,  and  where  any  material  divergence  exists  be- 
tween what  a  partner  does  and  what  he  should  do,  the 
attention  6f  each  partner  should  be  called  to  the  infraction 
noted. 


l86  AUDITING 

Business  men  are  beginning  to  appreciate  the  fact  that 
professional  accountants  are  able  to  advise  them  properly 
with  respect  to  the  accounts  necessary  to  prevent  dis- 
putes over  partnership  agreements.  As  accounts  are  the 
written  record  of  the  business,  it  follows  that  almost  all 
differences  of  opinion  between  partners  relate  to  the  ac- 
counts. A  lawyer  does  not  foresee  these  differences  and 
most  of  them  do  not  understand  accounts,  therefore  the 
accountant,  whose  experience  fits  him  to  point  out  in 
advance  the  various  matters  out  of  which  misunderstand- 
ings arise,  is  the  logical  adviser  and  insurer  against  many 
of  these  points  of  difference. 

The  duties  of  the  professional  auditor  are  not  always 
analytical;  prevention  is  better  than  cure,  so  that  when 
an  opportunity  presents  itself  whereby  litigation  and  other 
unfortunate  experiences  may  be  avoided,  it  is  his  clear 
duty  to  point  out  the  best  course  to  pursue. 

The  following  rules  cover  the  more  important  points 
in  partnership  agreements,  so  far  as  the  accounts  are 
concerned : 

1.  Nature  of  Business.  The  scope  of  the  business  and 
the  relation  of  each  partner  to  the  business  should  be 
clearly  stated,  also  whether  a  partner  is  permitted  to  en- 
gage in  outside  transactions  and  whether  or  not  each 
partner  is  required  to  devote  all  of  his  "time  to  the 
business. 

2.  Capital.  Specify  amount  to  be  contributed  by  each 
partner,  and  how  it  is  to  be  paid.  If  partners  agree  to 
contribute  equally,  the  agreement  should  state  whether 
cash  or  its  equivalent  is  to  be  provided  and  the  penalty, 
if  any,  for  the  failure  of  one  partner  to  contribute  as  much 
as  another. 

3.  Changes  in  Capital.  If  undrawn  profits  automati- 
cally increase  and  losses  decrease  the  capital  accounts  of 


BALANCE     SHEET    AUDIT— LIABILITIES  187 

the  partners,  the  agreement  should  cover  the  point  fully, 
as  the  interests  of  the  partners  in  capital  and  profits  may 
not  be  the  same. 

4.  Interest  on  Capital.  Unless  provided  for  in  the 
agreement,  capital  contributions  do  not  bear  interest.  If 
interest  is  to  be  allowed,  the  rate  should  be  fixed. 

5.  Withdrawals.  As  this  is  frequently  a  matter  of  dis- 
pute, explicit  provision  should  be  made  to  cover  the 
manner  and  extent  of  withdrawals  and  the  penalty  for 
overdrafts. 

6.  Undrawn  Profits.  If  profits  are  allowed  to  accumu- 
late, the  agreement  should  state  whether  such  amounts 
are  to  be  treated  as  loans  or  additional  capital.  This  pro- 
vision is  important,  as  clause  8  may  provide  that  profits 
are  to  be  apportioned  on  the  basis  of  capital. 

T.  Interest  on  Loans  or  Withdrawals.  If  it  is  desired 
that  interest  should  be  allowed  on  loans,  or  charged  on 
withdrawals,  so  state  and  specify  the  rate. 

8.  Distribution  of  Profits  or  Losses.  State  the  method 
of  apportioning  profits  or  losses  and  specify  each  partner's 
percentage,  also  any  contingency  which  may  affect  the 
share  of  any  one. 

9.  Approval  of  Accounts.  There  should  be  some  agree- 
ment as  to  the  approval  of  the  individual  partner's  ac- 
counts in  respect  to  withdrawals  as  well  as  to  the  profit 
and  loss  and  capital  accounts.  The  best  way  is  to  require 
each  partner  to  sign  his  respective  ledger  account. 

10.  Salaries  of  Partners.  If  any  partner  is  to  receive 
a  stated  salary,  specify  the  amount,  when  to  be  credited, 
whether  or  not  interest  is  to  be  allowed  thereon  if  un- 
drawn, and  whether  the  amount  is  to  be  charged  as  an 
expense  of  the  business  before  ascertaining  the  profit  or 
loss. 

11.  Dissolution.   State  procedure  if  partner  dies  or 


1 88  AUDITING 

withdraws;  whether  books  shall  be  balanced  at  once  or  al- 
lowed to  run  on  to  end  of  month  or  other  period;  whether, 
in  case  of  dissolution,  partners  are  to  share  losses  in  same 
proportion  as  each  one's  capital  bore  to  entire  capital. 

12.  Special  Causes  for  Dissolution.  If  partnership  can 
be  dissolved  for  other  reason  than  death,  such  as  disability 
or  intemperance,  state  complete  details. 

13.  Settlement  after  Dissolution.  It  is  important  not 
only  to  arrange  the  method  of  determining  each  partner's 
share  upon  dissolution,  but  it  is  equally  important  to  fix 
the  details  of  payment.  The  most  equitable  way  is  to  pro- 
vide for  full  payment  within  a  fixed  period,  or  to  pay  a 
certain  proportion  annually  or  semiannually.  State  rate 
of  interest  on  balance. 

14.  System  of  Accounts.  To  obviate  subsequent  dif- 
ferences of  opinion  as  to  the  system  of  accounts,  the  agree- 
ment should  specify  that  double-entry  accounts  be  kept, 
that  they  be  balanced  regularly,  and  that  they  be  audited 
annually  or  oftener  by  a  professional  accountant.  It  is 
desirable  that  the  method  of  selecting  the  auditor  be 
stated. 

15.  Disputes  about  Accounts.  An  arbitration  clause 
should  be  inserted  to  the  effect  that  if  any  dispute  arises 
involving  the  accounts,  it  is  to  be  submitted  for  settle- 
ment to  a  Certified  Public  Accountant  to  be  mutually 
agreed  upon.  As  disputes  occur  with  respect  to  other 
matters  as  well  as  to  the  accounts,  in  such  cases  the  ref- 
erence should  be  made  to  a  Certified  PubHc  Accountant 
and  a  lawyer,  with  power  lodged  in  them  to  select  a  third 
party  in  case  of  disagreement. 

16.  Firm  Insurance.  If  life  insurance  for  the  benefit 
of  the  firm  is  to  be  carried  on  the  life  of  one  or  more 
partners,  state  how  the  premiums  are  to  be  paid,  and 
the  disposition  of  the  proceeds  if  collected.     Also  state 


BALANCE     SHEET    AUDIT— LIABILITIES  189 

the  disposition  if  the  partnership  is  dissolved  while  the 
policy  is  in  force. 

The  following  argument  advanced  by  an  insurance 
solicitor  has  enough  merit  in  it  to  commend  it  to  the  at- 
tention of  every  professional  adviser: 

The  alert  intelligence  of  the  American  business  man  has  discovered 
in  life  insurance  a  most  valuable  assistance  in  establishing  his  credit, 
and  of  late  years  the  amount  of  insurance  taken  out  for  purely  business 
reasons  has  increased  enormously. 

Many  partnerships  have  been  crippled  by  the  death  of  a  partner 
at  a  crucial  period  in  their  existence.  In  every  properly  co-ordinated 
partnership  each  partner  is  a  specialist  in  the  department  over  which 
he  has  immediate  charge.  His  death  not  only  means  a  loss  in  efficiency 
which  competition  may  render  dangerous,  but  it  may  also  mean  the 
withdrawal  of  working  capital  at  a  time  when  the  replacing  of  it  would 
be  difficult,  if  not  impossible.  There  are,  moreover,  instances  where  it 
would  be  especially  desirable  to  buy  out  the  interest  of  the  estate  of  the 
deceased  and  thus  prevent  the  embarrassment  of  having  this  interest 
represented  by  a  person  ignorant  of  the  business  or  antagonistic  to  the 
other  partners.  In  fact,  the  more  highly  developed  and  successful  the 
copartnership,  the  greater  the  possibility  of  loss  through  the  death  of 
a  partner.  The  indemnity  which  life  insurance  offers  against  such  a 
loss  is  well  nigh  perfect,  inasmuch  as  upon  the  contingency  of  death 
the  policy  is  tantamount  to  a  sight  draft  upon  the  company  in  favor 
of  the  surviving  partners. 

Partnership  policies  may  be  taken  jointly  upon  the  lives  of  a  num- 
ber of  partners,  providing  upon  the  death  of  any  member  of  the  firm 
for  the  payment  of  the  face  of  the  policy  to  the  surviving  members. 
Should  the  partnership  be  dissolved,  however,  the  policy  could,  if  de- 
sired, be  converted  into  separate  insurances  for  equitable  amounts  upon 
the  lives  of  the  individuals  who  had  composed  the  firm.  Or  individual 
policies  may  be  taken  in  the  first  instance  upon  the  lives  of  each 
partner.  Upon  the  death  of  a  partner  the  insurance  upon  his  life  would 
be  paid  to  the  surviving  partners,  the  other  policies  remaining  un- 
affected. Upon  a  dissolution  of  the  partnership,  a  partner  could  pur- 
chase his  own  policy,  having  it  released  to  such  beneficiary  as  he  might 
elect,  and  continue  it  as  his  own  insurance.  This  privilege  is  especially 
valuable  when  the  health  of  the  insured  has  become  sufficiently  impaired 
to  make  it  impossible  for  him  to  obtain  new  insurance. 

17.  How  to  Avoid  Litigation.  In  litigation  between 
partners  it  has  been  held  that  where  partnership  books 


igQ  AUDITING 

exhibit  statements  of  account  and  entries  of  periodical 
settlement  and  partial  divisions  of  assets,  but  there  has 
been  no  final  accounting,  this  will  not  constitute  a  settle- 
ment or  account  stated  so  as  to  preclude  a  revision  of  the 
accounts. 

The  auditor  should  therefore  be  careful  in  accepting 
statements  of  clerks  or  one  partner  that  the  accounts 
were  settled  up  to  a  certain  date.  If  at  any  time  a  final 
settlement  had  been  made  the  words  "final  settlement  to 
this  point"  would  seem  to  be  necessary  to  preclude  the 
reopening  of  the  accounts  in  the  event  that  any  subse- 
quent dispute  should  arise. 

'The  binding  force  of  an  account  stated  will  not  be 
given  to  the  mere  furnishing  of  an  account  or  other 
transaction  which  was  not  with  a  view  to  asserting  a  claim, 
establishing  a  balance  due,  or  finally  adjusting  the  matters 
of  account  between  the  parties."     (Cyc.  1;  367.) 

18.  Good-Will.  If  withdrawing  partners  or  repre- 
sentatives of  deceased  partners  are  entitled  to  good-will, 
based  on  profits  or  otherwise,  state  the  method  of  calcu- 
lation in  detail.  For  instance,  if  salaries  of  partners  are 
treated  as  expenses  of  business  in  determining  annual  dis- 
tributions, state  whether  or  not  such  salaries  are  to  be 
likewise  treated  if  good-will  is  based  on  ^'average  net 
profits."  Salaries  of  partners  and  interest  on  partners' 
capital  are  in  reality  divisions  of  profit — not  expenses — - 
and  it  requires  a  clear  and  affirmative  agreement  to  deal 
with  them  as  expenses. 

CAPITAL  AND  SURPLUS 

Having  discussed  the  asset  side  of  the  balance  sheet, 
and  having  enumerated  all  of  the  obligations,  certain  and 
uncertain,  which  should  appear  on  the  opposite  side 
thereof,  the  auditor  should  devote  particular  attention  to 


BALANCE    SHEET    AUDIT— UABILITIES  191 

the  treatment  of  what  may  be  termed  the  net  worth  of  a 
firm  or  corporation.  By  this  is  meant  the  excess  of 
assets  over  liabilities.  This  forces  some  comments  which 
the  author  would  prefer  to  omit,  but  as  the  form  of  a 
balance  sheet  is  of  the  utmost  importance,  they  cannot 
be  avoided. 

Primarily  a  balance  sheet  is  prepared  for  the  informa- 
tion of  the  proprietors  whose  assets  and  liabiUties  are 
therein  set  forth.  In  practice  this  is  true  as  to  firms,  small 
corporations  and  large  corporations,  where  there  are  but 
few  stockholders.  In  the  case  of  corporations  with  nu- 
merous stockholders,  however,  it  is  well  known  that  the 
{balance  sheet  is  made  up  for  the  directors  or  those  who 
control,  rather  than  for  those  who  own. 

If  a  balance  sheet  were  always  intended  to  reach  the 
owners  of  the  business,  whose  sole  interest  therein  is  to 
ascertain  the  net  worth  of  their  property,  the  logical  form 
pf  a  balance  sheet  would  be  to  show  the  net  worth  clearly. 
But  this  is  not  done  when  assets  are  shown  on  one  side, 
and  on  the  other,  under  the  general  heading  "Liabilities," 
there  appear  in  this  order:  capital  stock  (not  a  liability), 
accounts,  and  notes  payable,  etc.,  reserves  (some  being 
liabilities,  some  not),  then  surplus,  the  total  exactly  agree- 
ing with  the  total  of  the  assets. 

The  average  investor  does  not  understand  accounts. 
How  is  he  to  determine  the  net  worth  of  the  business  of 
which  he  is  a  part  owner?  The  proper  way  to  enlighten 
him  is  to  classify  the  balance  sheet  items.  The  assets 
should  be  shown,  then  the  liabilities;  the  excess  of  assets 
over  liabilities  (if  any)  should  appear  next;  finally  the 
capital  or  capital  stock  and  surplus  representing  such 
excess.  If  it  is  desired  to  set  aside  part  of  the  surplus 
for  other  purposes,  the  segregation  should  be  shown  on 
the  balancti  sheet. 


IQ2  AUDITING 

This  grouping  can  be  used  where  it  is  desired  to  state 
the  assets  and  liabilities  in  parallel  columns  with  the  totals 
of  the  two  columns  in  agreement  (see  page  250),  as  well 
as  where  the  assets  are  first  stated,  then  the  liabilities 
thereunder,  followed  by  the  capital  plus  surplus,  or  capital 
less  deficit,  as  the  case  may  be.  (See  page  249.)  In  both 
cases  it  will  be  noticed  that  the  only  variation  of  any  con- 
sequence from  the  form  criticized  is  in  the  captions  and  the 
groupings.  But  these  are  read  seriously  by  many  business 
men,  so  that  care  should  be  taken  to  use  terms  as  nearly 
descriptive  of  the  items  to  which  they  apply  as  possible. 

There  is  really  very  little  defense  for  the  form  of  bal- 
ance sheet  which  shows  capital  and  surplus  as  liabilities, 
and  deficit  as  an  asset.  It  is  true  that  it  enables  an 
accountant  to  set  down  two  sets  of  figures  which  exactly 
balance,  and  the  author  freely  admits  that  the  best  cor- 
porations and  the  best  firms  of  accountants  use  the  form 
under  condemnation,  but  in  his  opinion  the  practice  is 
merely  the  outgrowth  of  custom  and  expediency  and  will 
be  changed  in  time. 

Capital  Stock 

The  auditor  should  examine  the  charter  or  certificate 
of  incorporation  of  the  corporation,  the  by-laws  and  the 
board  minutes  for  information  relative  to  the  authorized 
capital,  the  method  of  payment,  and  all  other  provisions 
governing  its  issuance.  He  should  ascertain  that  there 
has  been  no  overissue  by  examining  the  certificate  books 
and  stock  ledgers,  and  he  should  verify  the  proceeds  of  its 
sale.  In  most  states  capital  stock  cannot  be  issued  for 
a  consideration  less  than  its  par  value. 

Our  lax  laws,  however,  permit  almost  any  kind  and 
quantity  of  tangible  or  intangible  property  to  be  solemnly 
valued  at  any  conceivable  sum,  and  while  an  auditor  is  not 


BALANCE    SHEET    AUDIT— LIABILITIES  1Q3 

supposed  to  certify  to  anything  which  he  knows  is  not 
true,  still  we  have  not  yet  reached  the  point  where  an 
auditor  is  justified  in  volunteering-  an  opinion  that  capital 
stock  issued  in  payment  for  property  acquired  is  not  full 
paid  because  in  his  opinion  the  property  is  not  worth  the 
amount  of  stock  at  par  issued  therefor.  Of  course,  in  a 
special  investigation,  an  auditor  may  be  asked  to  investi- 
gate points  of  this  kind,  but  in  an  ordinary  audit  where 
stock  has  been  issued  for  property,  and  the  records  are 
in  satisfactory  shape,  the  auditor  is  not  called  upon  to 
challenge  the  good  faith  of  the  directors. 

Of  late  years  it  has  become  popular  to  adopt  by-laws 
which  call  for  certain  amounts  of  current  assets  to  be 
maintained,  for  certain  reserves  to  be  created,  etc.  The 
auditor  will  need  to  verify  all  of  these  requirements. 

If  stock  has  been  sold  on  *the  instalment  plan,  the 
auditor  will  ascertain  that  the  calls  have  been  promptly 
met  and  whether  any  are  in  arrears.  If  special  terms  have 
been  extended  to  any  stockholder,  approval  of  the  board 
is  necessary.  * 

Certificates  should  be  secured  from  transfer  agents  and 
registrars  if  any  are  acting  in  that  capacity  for  the  cor- 
poration under  audit.  If  the  stock  were  all  in  the  hands 
of  stock-brokers  or  financial  institutions,  it  might  be  as- 
sumed that  the  certificates  were  conclusive;  but  so  many 
stockholders  fail  to  insist  upon  the  simplest  precautions 
and  safeguards  that  it  may  be  taken  for  granted  that  in 
spite  of  the  blanks  on  the  face  of  the  certificates,  the 
average  stockholder  would  accept  as  genuine,  stock  cer- 
tificates which  did  not  bear  the  proper  signatures.  Fur- 
thermore, the  corporation  clerk  or  official  who  wishes  to 
defraud  will  cheerfully  fill  in  all  of  the  necessary  signatures 
if  necessary. 

Certificates  from  registrars  or  transfer  agents  should 


194  AUDITING 

in  all  cases  be  requested,  but  they  cannot  be  depended 
upon  as  conclusive  evidence  that  there  is  no  additional 
stock  outstanding. 

The  author's  attention  was  called  to  a  case  where  the 
president  of  a  bank  drew  certificates  of  stock  in  his  own 
name,  filling  out  the  stub  of  the  certificate  for  two  shares 
and  the  certificate  itself  for  two  hundred  shares.  The 
cashier  had  previously  signed  the  blank  certificates. 
Proper  payment  was  made  for  two  shares.  The  certifi- 
cate was  then  sent  to  the  registrar's  office  and  duly  re- 
corded as  being  for  two  hundred  shares.  The  president 
sold  this  stock  and  fraudulently  retained  the  proceeds. 
The  stock  was  not  fully  issued,  which  explains  the  action 
of  the  registrar;  if  there  were  an  overissue,  the  registrar 
would  refuse  to  validate  the  stock. 

In  this  case  the  certificate  of  the  registrar  would  have 
disclosed  the  fraud. 

Premiums  on  Capital  Stock 

Where  stock  has  been  sold  at  a  premium,  the  auditor 
will  see  that  all  premiums  have  been  collected.  The  funds 
so  realized  should  be  credited  to  Premiums  on  Capital 
Stock  account,  which  should  remain  open,  and  appear  on 
the  balance  sheet  as  a  special  surplus  account.  In  no 
event,  however,  should  the  account  be  transferred  to  gen- 
eral surplus  and  thus  be  looked  upon  as  available  for 
dividends.  It  would  probably  be  legal  to  declare  a  divi- 
dend out  of  funds  so  raised,  but  it  would  be  so  improper 
as  to  sustain  a  charge  of  dishonesty  against  the  director 
who  voted  therefor. 

Sinking  Fund  Accounts 

The  author  contends  that  reserves  for  depreciation, 
when  calculated  scientifically,  should  be  deducted  from 


BALANCE    SHEET    AUDIT— LIABILITIES  195 

the  assets  which  are  affected  thereby  or  else  be  shown  as 
liabilities.  If  it  should  happen  that  compulsory  sinking 
fund  requirements  exactly  agree  with  the  exhaustion  of 
mines  or  depletion  of  other  wasting  assets,  the  amounts 
thereof  will  likewise  appear  as  liabilities  and  depreciation 
reserves  are  unnecessary.  As  a  matter  of  fact,  however, 
sinking  fund  requirements  are  usually  in  excess  of  actual 
depreciation  or  exhaustion  reserves,  so  that  the  point  to 
be  settled  is  the  proper  method  of  showing  that  the  sink- 
ing fund  requirements  have  been  legally  complied  with 
and  at  the  same  time  exhibiting  the  assets  and  liabilities 
as  they  actually  exist. 

For  illustration,  a  mortgage  covering  coal  lands  may 
require  the  payment  to  the  trustee  of  a  sum  equal  to  ten 
cents  per  ton  mined.  The  exhaustion  charge  based  on 
engineers'  estimates  may  be  five  cents  per  ton.  The 
reason  for  the  difference  is  obvious.  The  holder  of  a 
bond  would  not  care  to  take  the  chance  of  waiting  for  the 
last  ton  to  be  removed  before  receiving  the  last  of  his 
principal. 

In  order  to  sell  bonds  the  security  must  be  ample  and 
a  considerable  margin  must  be  allowed  for  errors  in  esti- 
mates. No  doubt  the  mortgage  will  require  that  the 
sinking  fund  shall  be  a  charge  against  earnings,  and  this 
is  reasonable,  as  it  serves  to  prevent  excessive  dividends 
until  the  bonds  are  all  retired.  In  the  meantime,  however, 
there  is  no  reason  why  the  stockholders  should  be  kept 
in  ignorance  as  to  the  true  earnings  realized,  even  if  they 
are  not  entirely  available  for  dividends  so  long  as  the 
bonds  remain  unpaid. 

Therefore,  the  only  way  to  show  the  exact  (or  as 
nearly  exact  as  possible)  earnings  would  be  to  carry  a 
reserve-for-exhaustion  account  among  the  liabilities  equal 
to  five  cents  per  ton,  and  a  reserve-for-sinking-fund  ac- 


1^6  AUDITING 

count  equal  to  an  additional  five  cents  per  ton  as  a  segre- 
gated part  of  the  surplus.  After  all  of  the  bonds  are  re- 
tired this  reserve  account  would  be  closed  into  the  general 
surplus  account. 

The  reserve-for-exhaustion  account  should  be  suffi- 
cient to  equal  the  book  value  of  the  property  account  by 
the  time  the  coal  is  practically  exhausted.  This  rule  ap- 
plies irrespective  of  any  special  requirements  for  sinking 
fund  instalments,  and  irrespective  of  a  trust  deed  provi- 
sion that  such  instalments  are  a  charge  against  income. 
All  fixed  or  wasting  assets  must  be  kept  intact,  either  in 
their  original  form  or  by  creating  an  equivalent  in  cash 
or  some  other  satisfactory  asset.  The  amounts  required 
to  maintain  this  equilibrium  are  charges  against  income, 
but  as  soon  as  the  instalments  are  in  excess  of  such  re- 
quirements, the  excess  forms  a  part  of  the  surplus  of  the 
business  and  should  be  shown  as  such.  The  question  as 
to  how  much,  if  any,  of  the  surplus  is  available  for  divi- 
dends is  another  matter. 

Reserve  for  Working  Capital 

It  has  been  held  to  be  legal  to  set  aside  annually  or 
at  other  periods  out  of  the  earnings  of  a  company  a  rea- 
sonable amount  as  a  reserve  for  additional  working 
capital,  which  is  therefore  not  distributable  in  the  shape 
of  dividends.  This  reserve  may  be  temporary  or  perma- 
nent, as  the  directors  may  determine,  and  corresponds 
with  the  surplus  of  a  bank  or  trust  company,  which  is 
never  used  for  the  purpose  of  dividends  unless  some  ex- 
traordinary occasion  arises.  The  account  is  a  discre- 
tionary one  and  is  almost  entirely  a  matter  of  book- 
keeping, or  rather  it  is  a  sort  of  notice  to  stock- 
hcflders  that  the  amounts  so  set  aside  will  not  be 
distributed. 


BALANCE    SHEET    AUDIT— LIABILITIES  107 

To  treat  such  an  account  as  a  liability  is  a  fallacy, 
because  at  any  time  the  directors  can  transfer  the  entire 
balance  to  general  surplus  and  pay  out  all  or  any  part  of 
it  in  dividends.  Therefore  the  account  should  always  ap- 
pear on  the  balance  sheet  as  a  section  of  surplus,  and 
never  among  the  liabilities.  An  auditor  should  never  set 
up  an  account  of  this  nature  in  the  books  nor  show  it 
on  the  balance  sheet  unless  it  has  been  formally  author- 
ized by  the  board  of  directors.  It  is  a  most  commendable 
practice  to  accumulate  a  substantial  surplus,  and  if  the 
directors  believe  that  the  temptation  to  declare  dividends 
will  be  less  if  the  surplus  account  proper  is  diminished 
and  some  other  account  with  a  different  name  is  increased, 
the  auditor  cannot  object.  But  no  such  diversion  of 
profits  should  be  attempted  by  an  oflficer  of  a  company  on 
his  own  initiative. 

Preferred  Stock  Accumulated  Dividends,  etc. 

Capital  stock  is  not  a  liability,  nor  can  a  dividend 
thereon  be  a  liabiHty  unless  action  has  been  taken  and  the 
funds  set  aside  for  the  purpose.  When  this  is  once  done 
the  action  of  the  directors  cannot  be  rescinded  and  the 
dividend  becomes  a  liability. 

But  a  situation  sometimes  exists  with  respect  to  un- 
paid dividends  on  preferred  stock  which  are  entitled  to 
accumulate  in  favor  of  the  preferred  stock  until  paid  or 
otherwise  disposed  of.  This  preference,  however, .  is  a 
factor  only  as  against  the  common  stock.  It  does  not 
accumulate  as  a  liability  and  is  not  deductible  from  the 
surplus,  if  any,  which  exists.  In  other  words,  a  corpora- 
tion may  have  a  book  surplus  more  than  sufficient  to  pay 
accumulated  preferred  stock  dividends,  but  so  long  as  no 
dividend  is  declared  by  the  directors  no  book  entry  is 
permissible.    The  balance  sheet  will  not  reflect  the  aggre- 


198  AUDITING 

gate  of  the  unpaid  dividends  unless  it  is  noted  thereon  as  a 
memorandum. 

Common  stockholders  usually  have  a  keen  interest  in 
the  value  of  their  shares,  and  it  is  not  only  permissible, 
but  desirable,  that  any  arrears  which  may  exist  with  re- 
spect to  accumulated  dividends  should  appear  as  a  foot- 
note or  memorandum  on  the  balance  sheet. 

A  matter  of  increasing  interest  in  connection  with  pre- 
ferred stock  issues  is  the  obligation  to  retire  part  of  an 
issue,  usually  at  a  considerable  premium,  at  fixed  dates, 
or  under  other  conditions.  In  most  cases  these  provisions 
are  agreed  to  at  the  formation  or  refinancing  of  a  com- 
pany and  at  a  time  when  the  future  prospects  seem  to 
warrant  large  appropriations  out  of  earnings  for  the  pur- 
pose of  retiring  preferred  stock.  Unfortunately  these  op- 
timistic forecasts  have  not  been  realized,  and  there  have 
been  many  defaults  in  this  respect. 

The  question  arises  as  to  the  change  of  status,  if  any, 
on  the  part  of  a  stockholder  owning  stock  in  respect  of 
which  a  default  exists.  For  instance,  a  corporation  sold 
$750,000  of  first  preferred  stock,  with  a  provision  for  the 
retirement  of  $150,000  annually  after  a  certain  period  hid 
elapsed.  When  the  first  instalment  became  due  the  cor- 
poration was  unable  to  meet  its  obligation.  There  was 
no  provision  in  the  certificate  bearing  on  the  treatment  of 
the  overdue  payment  in  the  accounts  or  the  balance 
sheets.  The  auditors  declined  to  certify  the  balance  sheet 
until  a  decision  was  reached  as  to  whether  or  not  the 
amount  represented  a  liability  to  be  liquidated  as  soon  as 
funds  were  available.  So  long  as  this  possibility  existed 
the  position  of  the  general  creditors  was  subject  to 
change.  Finally  it  was  decided  to  secure  an  extension 
from  all  stockholders  and  upon  satisfactory  evidences 
thereof  the  auditors  passed  the  balance  sheet, 


BALANCE    SHEET    AUDIT— LIABILITIES 


199 


No  general  rule  can  be  laid  down  for  the  auditor's 
guidance  in  such  cases  as  this,  as  each  case  must  be  de- 
cided on  its  merits.  The  most  important  facts  for  the 
auditor  to  ascertain  are  the  rights  of  stockholders  to  in- 
sist upon  payment,  and  the  aggregates  and  due  dates  of 
all  probable  obligations.  Their  disposition  in  the  ac- 
counts is  then  a  matter  of  disclosing  full  information  to 
creditors,  prospective  creditors,  and  to  other  stockholders. 

Surplus 

This  should  be  the  last  word  on  the  balance  sheet,  and 
it  should  have  as  specific  a  meaning  as  any  item  of  assets 
or  liabilities.  This  is  rarely  the  case,  however,  and 
auditors  are  as  much  to  blame  for  this  condition  as 
anyone  else. 

The  ''surplus"  of  a  corporation  should  represent  an 
actual  surplus,  that  is,  a  balance  of  net  profits  after  all 
reserves  have  been  provided,  including  the  reserves  out  of 
surplus,  such  as  working  capital,  etc.,  leaving  an  amount 
safely   distributable  as   dividends. 

This  does  not  mean  that  there  must  be  cash  on  hand 
sufficient  to  pay  the  whole  amount  of  surplus  in  divi- 
dends, but  that  if  at  any  time  there  should  be  surplus 
funds,  the  directors  may  rely  on  the  integrity  of  the  sur- 
plus account  and  not  lay  themselves  open  to  an  action 
for  paying  dividends  out  of  capital,  or  before  reserves  for 
compulsory  sinking  funds,  etc.,  have  been  created. 

Investment  of  Surplus 

Common  questions  with  respect  to  the  surplus  ac- 
count are:  ''Where  is  it?"  "What  asset  represents  it?" 
etc.  Any  one  familiar  with  accounts  understands  that  no 
good  reason  exists  for  attempting  to  earmark  certain  as- 
sets as  an  investment  of  surplus;  but  there  is  some  foun- 


200  AUDITING 

dation  for  the  skepticism  which  exists  as  to  the  availability 
of  many  so-called  surplus  accounts. 

The  best  answer  an  auditor  can  give  to  these  questions 
is  to  say  that  if  the  assets  are  not  overvalued,  the  surplus 
is  well  invested  therein;  and  if  any  or  all  of  the  assets  are 
overvalued,  then  the  surplus  does  not  exist  to  the  extent 
of  the  overvaluation. 


CHAPTER   X 

PROFIT    AND    LOSS    ACCOUNT 

At  least  nine-tenths  of  all  the  enterprises  with  which  a 
professional  auditor  has  to  deal  are  conducted  with  the 
expectation  of  realizing  a  profit.  Certainly  more  than 
half,  and  probably  three-fourths,  of  these  enterprises  have 
their  accounts  stated  and  results  shown  in  a  form  to  which 
a  professional  auditor  cannot  certify  without  modification 
or  adjustment.  That  is  to  say,  most  concerns  state  their 
profit  and  loss  accounts  incorrectly. 

There  are  frequent  differences  of  opinion  with  respect 
to  a  balance  sheet,  but,  after  all,  it  is  not  usually  diffi- 
cult to  reach  an  agreement  as  to  the  amount  at  which  the 
assets  and  liabilities  shall  be  stated  when  they  are  com- 
piled from  the  books  and  adjusted  to  meet  known  condi- 
tions, including  valuations  of  disinterested  persons  and 
the  scheduling  of  all  known  liabilities.  Reliable  appraisal 
companies  will  place  valuations  upon  all  the  physical 
property.  As  to  other  assets  and  liabilities,  there  is  rarely 
any  serious  question  of  the  amounts  stated  by  the  auditor. 
But  as  soon  as  an  attempt  is  made  to  state  a  definite  and 
final  amount  which  represents  the  net  profit  of  any  con- 
cern for  a  given  period,  there  arises  the  most  diffi- 
cult and  unsatisfactory  problem  which  an  auditor  must 
solve. 

In  view  of  the  fact  that  there  is  scarcely  any  likelihood 
that  two  professional  auditors  today  would,  with  respect 
to  the  accounts  of  an  undertaking  of  any  considerable 

20 1 


202  AUDITING 

magnitude,  show  the  same  net  result  of  profit,  it  is  not 
surprising  that  the  usual  profit  and  loss  account  is  pre- 
pared upon  a  basis  which  admits  of  criticism.  It  is 
extremely  important  that  an  effort  be  made  to  establish 
standards  which  will  appeal  to  those  responsible  for  the 
stating  of  accounts  as  scientific  and  reasonable.  The  lat- 
ter term  may  seem  out  of  place,  but  it  must  be  under- 
stood that  rules  which  are  purely  theoretical  will  not  be 
observed. 

It  is  not  difficult  to  write  out  a  memorandum  of  the 
items  which  appear  on  the  debit  and  credit  sides  of  the 
profit  and  loss  account,  but  unfortunately  in  actual  prac- 
tice the  items  assume  so  many  different  aspects  that  all 
of  the  rules  heretofore  published  have  failed  to  furnish  a 
practical  method  of  handling  them.  It  is  the  purpose  of 
this  chapter  to  discuss  theories,  both  legal  and  profes- 
sional, and  follow  up  the  theories  by  illustrations  which, 
while  they  may  not  establish  a  standard  upon  which  all 
will  agree,  may  nevertheless  assist  those  who  desire  to 
study  the  suggestions  of  others  as  a  means  of  arriving  at 
their  own  conclusions. 

A  balance  sheet  audit  is  only  partially  completed  with 
the  verification  of  the  assets  and  liabilities.  There  will  be 
shown  thereon  a  deficit  or  a  surplus,  and  it  is  absolutely 
impossible  to  form  any  intelligent  conclusion  as  to  the 
operations  of  a  business  unless  an  analysis  in  the  form 
of  a  profit  and  loss  statement  accompanies  the  balance 
sheet.  It  is  not  enough  to  know  that  the  balance  sheet 
shows  a  substantial  surplus;,  the  preceding  balance  sheet 
may  have  shown  a  much  larger  one! 

It  is  not  enough  to  know  that  the  profit  or  loss  for 
a  particular  period  is  a  certain  sum.  All  who  are  inter- 
ested in  the  enterprise  desire  to  know  the  particulars  of 
the  net  result,  and  the  auditor  who  states  the  transactions 


PROFIT    AND    LOSS    ACCOUNT 


203 


in  an  intelligent,  scientific,  readable  way  is  the  one  who 
finds  favor  with  business  men. 

The  form  of  the  statement  and  related  subjects  are 
fully  discussed  in  the  chapter  on  certificates  and  reports 
(page  235). 

It  is  proper  to  mention  at  this  point,  however,  that 
the  auditor  who  familiarizes  himself  with  the  legal  as  well 
as  the  economic  aspects  of  income  and  expense  accounts 
is  best  prepared  to  analyze  accounts  properly  and  to  pre- 
sent the  results  so  that  the  relation  of  certain  figures  or 
groups  of  figures  will  convey  all  that  they  should  convey. 

Legal  Definition  of  Profits 

The  courts  in  different  jurisdictions  have  defined 
profits,  net  profits  and  profits  available  for  dividends,  in 
so  many  different  ways  that  an  auditor  or  corporate  offi- 
cer who  desires  authority  for  any  position  which  he 
desires  to  assume  can  usually  find  it  in  the  law  reports. 

It  has  been  held  in  judicial  decisions  that  a  dividend 
may  be  declared  out  of  the  profits  of  one  year  although 
there  is  a  large  deficit  carried  over  from  previous  years, 
and  that  "past-due  floating  debt  should  be  paid  or  funded 
before  a  dividend  is  declared."  Nearly  every  conceivable 
situation  between  these  two  extremes  has  been  held  to  be 
legal  or  illegal,  depending  on  the  judge  deciding  the  case. 

In  many  of  the  decisions  profits  are  defined  and  the 
ludicrous  definitions  and  comments  in  themselves  explain 
why  it  is  that  the  courts  vary  to  such  a  great  extent  in 
settling  disputes  which  involve  accounts.  The  fact  is  that 
judges,  who  are  trained  as  lawyers,  understand  as  little 
about  accounts  as  the  members  of  the  bar.  The  adage 
'*A  little  knowledge  is  a  dangerous  thing"  has  its  exempli- 
fication in  the  treatment .  by  lawyers  of  questions  of 
accounting.    They  have  the  temerity  to  settle  matters  of 


204 


AUDITING 


the  greatest  importance,  involving  complicated  accounts, 
without  any  evidence  that  anyone  who  understands 
accounts  has  been  consulted  in  the  settlement.  Occa- 
sionally an  instance  is  found  where  the  departure  from  the 
usual  legal  comment  is  so  great  that  it  is  worth  placing 
on  record.    The  court  said  in  one  case  in  point: 

If  at  the  end  of  the  first  year  the  line  of  railway  is  still  in  so  good  a 
state  of  repair  that  it  requires  nothing  to  be  laid  out  on  it  for  repairs 
in  that  year,  still,  before  you  can  ascertain  the  net  profits,  a  sum  of 
money  ought  to  be  set  aside  as  representing  the  amount  in  which  the 
wear  and  tear  of  the  line  has,  I  may  say,  so  far  depreciated  it  in  value 
that  that  sum  will  be  required  for  the  next  year  or  next  two  years.  I 
should  think  no  commercial  man  would  doubt  that  this  is  the  right 
course — that  he  must  not  calculate  net  profits  until  he  has  provided  for 
all  the  ordinary  repairs  and  wear  and  tear  occasioned  by  his  business. 
That  being  so,  it  appears  to  me  that  you  can  have  no  net  profits  unless 
this  sum  has  been  set  aside.  When  you  come  to  the  next  year,  or  the 
third  or  fourth  year,  what  happens  is  this:  as  the  line  gets  older  the 
amount  for  repairs  increases.  If  you  had  done  what  you  ought  to  have 
done,  that  is,  set  aside  every  year  the  sum  necessary  to  make  good  the 
wear  and  tear  in  that  year,  then  in  the  following  years  you  would  have  a 
sum  sufficient  to  meet  the  extra  cost. 

Another  legal  definition  of" net  profits  is  the  following: 

Theoretically  all  profits  are  "net,"  but  as  the  expression  "gross 
profits"  is  sometimes  used  to  describe  the  mere  excess  of  present  value 
over  former  value,  or  of  returns  from  sales  over  prime  cost,  the  phrase 
"net  profits"  is  appropriate  to  describe  the  gain  which  remains  after 
the  further  deduction  of  all  expenses,  charges,  costs,  allowance  for' 
depreciation,  etc. 

In  a  New  York  decision  often  cited,  the  court  used  the 
following  language : 

It  is  undoubtedly  true  that  "profit"  and  "income"  are  sometimes 
used  as  synonymous  terms;  but,  strictly  speaking,  "income"  means  that 
which  comes  in  or  is  received  from  any  business  or  investment  of 
capital,  without  reference  to  the  outgoing  expenditures,  while  "profits" 
generally  mean  the  gain  which  is  made  upon  any  business  or  investment 
when  both  receipts  and  payments  are  taken  into  account.  "Income" 
when  applied  to  the  affairs  of  individuals,  expresses  the  same  idea  that 


PROFIT    AND    LOSS    ACCOUNT 


205 


"revenue"  does  when  applied  to  the  affairs  of  a  state  or  nation ;  and 
no  one  would  think  of  denying  that  our  government  has  any  revenue, 
because  for  a  stated  period  the  expenditures  may  exceed  the  amount  of 
the  receipts.* 

Economic  Definition  of  Profits 

In  discussing  the  subject  of  profits  the  "Encyclopedia 
of  Accounting"  states  that  from  an  economist's  point  of 
view  profit  consists  of  the  surplus  remaining  over  from  the 
employment  of  capital  after  defraying  all  the  necessary 
expenses  and  outlays  incurred  in  its  employment,  and 
after  the  capital  has  been  replaced  or  provision  made  for 
its  replacement.  If  there  are  not  sufficient  assets  left  to 
replace  the  capital,  the  result  of  the  venture  or  employ- 
ment is  a  loss  and  the  amount  by  which  the  capital  is 
diminished  is  the  measure  of  .this  loss.  Profits  are  arrived 
at  by  means  of  balance  sheets  sho^ying  the  true  financial 
position  of  the  concern,  supplemented,  where  the  books 
are  properly  kept,  by  a  profit  and  loss  account. 

For  example,  the  profit  of  a  company  for  the  first  year 
would  be  the  excess  of  assets  over  liabilities  (including  in 
the  latter  the  paid  up  capital),  while  there  would  be 
exhibited  in  the  profit  and  loss  account  the  sources  from 
which  the  profits  have  arisen.  The  profit  for  any  period 
is  the  difference  between  the  surplus  of  assets  over  liabili- 
ties at  the  beginning  of  the  year  and  the  surplus  as  shown 
at  the  close. 

Accountant's  Definition  of  Profits 

If  a  public  accountant  were  asked  to  define  the  term 
"net  profit"  he  would  probably  reply:  "The  net  profit  of 
a  business  is  the  surplus  remaining  from  the  earnings  after 
providing  for  all  costs,  expenses,  and  reserves  for  accrued 
or  probable  losses." 


Teoole  V.  Niagara  County  Supervisors,  4  Hill  (N.  Y.)  20. 


206  •  AUDITING 

But  there  are  capital  profits  and  revenue  profits,  as  for 
instance,  part  of  a  tract  of  land  upon  which  a  "factory  has 
been  erected  may  be  sold  for  an  amount  equal  to  the  orig- 
inal cost  of  the  entire  undertaking.  This  is  a  realized 
profit,  but  not  one  which  falls  within  the  ordinary  defi- 
nition, therefore  it  is  not  wise  to  rely  exclusively  upon 
any  one  definition. 

As  stated  on  page  199,  the  author  believes  that  the 
word  ''surplus"  should  be  used  only  to  designate  an 
amount  available  for  dividends.  The  term  net  profits 
should  be  used  only  to  designate  the  amount  arrived  at 
by  stating  the  income  actually  accrued  during  a  stated 
period,  collected  or  collectable,  less  the  cost  thereof,  and 
after  provision  is  made  for  further  costs  accrued  but  not 
paid,  such  as  depreciation,  obsolescence,  taxes,  and  other 
charges  apportioned  against  the  income,  such  as  reserves 
for  strikes,  workmen's  pensions,  etc.,  but  before  any 
reserve  is  created  for  working  capital,  unknown  contin- 
gencies, etc.  If  an  absolutely  accurate  balance  sheet 
could  be  prepared  at  the  beginning  and  end  of  a  period, 
the  difference  would  represent  the  net  profit  or  net  loss 
for  the  term,  but  the  valuation  and  revaluation  of  capital 
assets  involves  too  much  speculation  to  permit  such  a 
practice  being  recognized  as  satisfactory.  This,  in  effect, 
is  the  method  used  in  arriving  at  results  in  a  single-entry 
business,  and  its  utter  failure  to  justify  itself  is  reason 
enough  for  abandoning  it. 

A  business  man  wants  to  know  his  gross  earnings  for 
the  year,  together  with  all  of  the  costs  and  expenses  which 
are  properly  chargeable  thereto.  Naturally  the  net  result, 
be  it  a  profit  or  a  loss,  will  coincide  with  the  changes  in 
the  balance  sheet  at  the  beginning  and  the  end,  exclusive 
of  capital  receipts  or  expenditures  during  the  period.  But 
the  business  man  does  not  always  think  that;  sometimes- 


PROFIT    AND    LOSS    ACCOUNT 


207 


he  wants  to  have  the  gross  earnings  stated  and  as  few 
deductions  therefrom  as  possible  made,  in  order  that  a 
favorable  result  may  be  shown.  He  may  be  willing  to 
create  a  reserve  for  depreciation  on  the  books,  and  in  the 
income  tax  returns,  but  he  does  not  always  want  it  to 
appear  in  the  statement  which  he  shows  his  banker.  He 
does  not  consider  that  the  profit  and  loss  account  as  he 
would  state  it,  taken  in  connection  with  his  balance  sheets, 
would  be  inaccurate  on  its  face.  The  professional  auditor, 
however,  is  under  a  much  greater  responsibility.  He  can- 
not afford  to  prepare  a  profit  and  loss  account  which  omits 
any  material  item.  Just  what  should  be  included  and  what 
excluded  will  now  have  our  attention. 

EARNINGS 
Gross  Earnings 

It  is  customary  and  desirable  to  show  the  gross  business 
transacted,  whether  arising  from  sales  of  goods,  services 
rendered  by  professional  men  and  others,  or  by  public  service 
corporations  or  similar  enterprises. 

Returns 

Where  earnings  arise  from  the  delivery  of  goods  and 
for  any  reason  the  goods  are  returned,  the  aggregate  thereof 
is  usually  deducted  from  the  gross  sales  before  stating  same. 
The  reason  for  this  is  that  if  the  goods  are  returned  and 
credited  at  the  same  price  at  which  charged,  and  are  avail- 
able for  resale,  then  it  would  be  improper  to  augment  the 
sales  by  transactions  never  consummated,  and  thus  render 
less  valuable,  calculations  of  gross  profits,  etc.  This  is  the 
general  rule,  but  if  anyone  for  whom  a  statement  is  being 
prepared  desires  to  have  the  returns  shown  as  a  deduction 
from  the  gross  sales,  there  is  no  objection  to  complying 
with  the  request.  It  may  be  of  interest  as  a  means  of  show- 


2o8  AUDITING 

ing  whether  the  proportion  of  returns  to  the  total  volume 
of  business  is  proper  or  otherwise. 

Ordinary  Transactions  Only  to  be  Included 

/  It  should  be  noted  here  that  in  the  first  division  of  the 
profit  and  loss  account  the  only  earnings  which  should  be 
shown  are  those  which  are  incident  to  the  normal  operation 
of  the  business.  All  other  earnings  should  be  excluded 
at  this  point.  The  reason  for  this  is  that  the  relation 
of  one  account  to  another,  for  immediate  observation  as 
well  as  for  future  comparative  purposes,  must  be  expressed 
in  percentages  and  amounts  and  the  inclusion  of  any  item  out 
of  the  ordinary  scope  of  the  enterprise  would  affect  the 
percentages  and  thus  diminish  the  value  of  the  comparisons. 

Allowances  and  Rebates 

These  are  the  next  deductions  and  will  also  be  direct, 
except  that  separate  ledger  accounts  should  be  kept  therefor, 
unless  the  items  are  few  in  number  and  amount.  Wherever 
the  aggregate  is  a  material  percentage  .of  the  gross  sales, 
and  therefore  subject  to  comment  and  possible  criticism,  it 
should  be  shown  on  the  statement. 

Bad  Accounts 

The  earnings  just  referred  to  are  gross  and  are  so 
stated  whether  or  not  realized  in  cash  or  its  equivalent.  The 
question  arises  as  to  whether  an  allowance,  or  reserve,  for 
bad  accounts  should  be  considered  at  this  stage  and  be  de- 
ducted direct  from  the  gross  earnings,  or  be  treated  as  an 
expense  of  administration  or  selling  and  be  included  under 
one  of  these  groups.  The  proper  place  is  that  group  which 
reflects  the  cost  of  collecting  the  proceeds  of  the  sales. 

One  concern  may  decide  to  take  its  chances  on  the 
acumen  of  its  salesmen  and  maintain  no  credit  department. 
The  proportion  of  bad  accounts  may  be  fairly  large,  but  may 


PROFIT    AND    LOSS    ACCOUNT 


209 


not  be  sufficient  to  warrant  the  expense  of  a  competent 
credit  force.  Another  concern  in  the  same  line  of  business 
may  have  a  well-equipped  credit  department  and  its  losses 
from  bad  accounts  may  be  very  small,  but  there  will  be  two 
items  of  expense  to  be  grouped  if  an  intelligent  comparison 
with  the  other  concern  is  desired.  For  these  and  other 
reasons  the  provision  for  bad  accounts  should  not  be 
deducted  directly  from  the  earnings. 

The  reserve  created,  however,  is  a  deduction  from  the 
item  of  trade  debtors  or  accounts  receivable  on  a  balance 
sheet.  It  is  not  a  liability  and  should  never  be  placed 
among  liabilities  or  on  the  liability  side  of  the  balance 
sheet.  f    , 

Work  in  Progress 

So  far  as  the  books  of  account  are  concerned  a  clear 
line  must  be  drawn  between  earnings  which  are  represented 
by  completed  transactions  with  trade  debtors  and  those 
which  are  only  partially  completed.  In  any  case  no  profit 
must  be  taken  unless  a  cause  of  action  has  arisen  which  can 
be  enforced  against  the  debtor.  In  other  words,  where 
work  in  progress  cannot  be  earmarked  as  for  a  definite  cus- 
tomer, or  where  it  has  not  proceeded  far  enough  to  base  an 
action,  it  must  be  taken  into  the  inventory  at  cost  and  no 
profit  thereon  will  appear  in  the  profit  and  loss  account. 
But  if  work  is  undertaken  ''on  order"  and  is  proceeding 
satisfactorily,  and  it  is  apparent  that  the  estimated  profit 
thereon  will  be  realized,  more  or  less,  then  it  is  permissible 
to  take  credit  for  the  proportion  of  profit  earned  to  the  date 
of  the  account. 

Ordinarily,  on  the  theory  that  profits  must  not  be  an-, 
ticipated,   this  principle   would  not  be  considered   a   con- 
servative one.     In  trading  concerns  orders  are  frequently 
taken  far  in  advance,  and  goods  in  an  inventory  may  have 


2IO  AUDITING 

been  sold  and  be  simply  awaiting  delivery.  Accounting 
authorities  agree  that  the  profit  on  such  sales  should  be 
deferred  to  the  period  during  which  delivery  is  made. 

It  may  therefore  be  pertinent  to  inquire  why  it  is  that 
a  profit  may  be  taken  on  a  contract  only  partially  completed 
and  with  many  contingencies  to  face,  any  one  of  which  might 
delay  or  prevent  the  contract  being  fulfilled  according  to  its 
terms.  Perhaps  the  best  and  frankest  answer  to  this  argu- 
ment is  that  expediency  governs  one  case,  while  the  other 
is  subject  to  ordinary  commercial  practice. 

Most  concerns  w^hich  sell  ahead  have  a  fairly  constant 
and  uniform  business  and  no  statistical  problem  is  affected 
by  charging  sales  expenses  to  one  period  while  the  follow- 
ing period  reaps  the  benefit  thereof.  But  a  shipbuilder  may 
have  at  the  end  of  one  fiscal  period  a  dozen  jobs  under  way, 
while  at  the  end  of  the  next  period  he  may  have  six  or 
eighteen.  If  he  were  to  take  in  the  profit  on  completed  jobs 
only,  his  books  might  show  a  state  of  affairs  vastly  different 
from  the  facts,  that  is,  his  most  prosperous  year  might 
easily  show  up  the  worst.  The  same  condition  exists  with 
contractors  in  the  building  and  other  trades. 

It  may  be  urged  that  the  taking  of  a  profit  on  uncom- 
pleted work  is  an  extreme  case  of  anticipating  earnings,  a 
practice  which  is  condemned  throughout  this  book.  This 
is  admitted.  It  should  be  borne  in  mind,  however,  that  in 
all  cases  w^here  there  are  inventories  and  similar  assets  the 
closing  of  books  is  necessarily  based  on  estimates,  and  many 
instances  are  known  of  serious  mistakes  in  fixing  valuations 
on  real  estate  and  stock-in-trade. 

The  necessity  of  closing  at  a  fixed  date  each  year  may  be 
supported  by  careful  estimates,  and  it  will  be  found  over  a 
period  of  years  that  a  contractor  who  has  carefully  esti- 
mated the  value  of  work  in  progress,  and  who  has  con- 
servatively estimated  his  profits  thereon,  will  have  arrived 


PROFIT    AND    LOSS    ACCOUNT  ^11 

at  figures  quite  as  dependable  as  is  the  case  in  a  business 
where  the  units  of  production  are  smaller  and  where  it  is 
not  the  practice  to  anticipate  profits.  Experience  in  deal- 
ing with  contractors'  accounts  soon  enables  the  auditor  to 
verify,  at  least  approximately,  the  accuracy  of  the  figures 
submitted  in  connection  with  work  in  progress. 

Recently  the  practice  of  having  work  done  at  a  maximum 
profit  or  upon  a  fixed  percentage  has  been  extended  to  much 
work  which  formerly  was  undertaken  for  a  round  sum.  In 
such  a  case  the  profit  is  determined  by  the  extent  of  the 
work  completed  and  may  be  taken  into  account  in  the  same 
manner  as  with  professional  earnings. 

Where  the  units  of  production  are  smaller  and  the  time 
of  completion  is  comparatively  short,  there  is  no  sanction 
for  including  any  profit  whatever  in  the  inventory  prices  of 
unfinished  goods.    Under  a  very  accurate  and  carefully  kept 
cost  system  it  may  be  possible  to  arrive  at  the  cost  price  of 
work  in  progress.     The  auditor  should  ascertain  that  the\ 
principles  upon  which  the  costs  have  been  calculated  are  ]  ^ 
correct  and  should  also  satisfy  himself  that  the  quantities  j 
have  been  checked  and  certified  to  by  responsible  parties.      y 

Departmental  Profits 

It  has  been  held  by  some  accounting  authorities  that 
when  the  product  of  one  department  of  a  business  has  been 
completed  and  is  turned  over  to  another  department,  the 
originating  department  may  take  credit  for  its  production 
at  the  market  price,  and  if  the  market  price  is  in  excess  of 
its  cost,  then  a  profit  is  earned  and  may  be  taken  into  account 
immediately. 

In  support  of  this  view  it  is  pointed  out  that  in  some 
concerns  there  may  be,  say,  four  distinct  stages  between  raw 
product  and  finished  goods.  Other  and  competing  concerns 
may  deal  only  with  one,  two,  or  three  of  these  stages,  so 


212  AUDITING 

that  what  may  be  an  intermediary  stage  for  one  will  rep- 
resent raw  materials  for  another. 

For  instance,  a  steel  plant  may  mine  its  own  ore  and 
manufacture  its  own  pig  iron.  A  competitor  may  purchase 
all  of  its  pig  iron.  The  former's  iron  may  cost  $10  per 
ton ;  the  latter,  having  to  buy  on  the  market,  may  not  be 
able  to  secure  any  iron  under  $12  per  ton. 

The  iron  may  be  used  to  manufacture  identical  products. 
At  what  price  should  the  former  concern  charge  the  de- 
partment to  which  the  iron  is  delivered?  If  at  $10  per 
ton,  the  manager  will  be  credited  with  a  lower  cost  on  his 
production  than  his  competitor,  although  the  latter  may,  as 
a  matter  of  fact,  be  more  efficient. 

So  far  the  argument  is  a  strong  one,  and  the  point  can 
be  conceded  if  the  interdepartmental  profits  are  suspended 
until  the  product  is  finally  disposed  of.  Otherwise  a  concern 
manufacturing  its  goods  from  the  first  stage  to  the  last 
might  find  itself  with  a  large  inventory  of  manufactured 
goods  and  a  large  apparent  profit  and  yet  be  wholly  unable 
to  convert  the  book  profit  into  cash. 

For  comparative  purposes  and  in  order  to  determine  the 
efficiency  of  different  departments,  it  may  therefore  be  per- 
missible to  adjust  costs  to  market  prices  provided  that  in 
all  cases  such  intermediate  profits  be  held  in  reserve  until 
there  has  been  a  conversion  into  cash  or  its  equivalent. 

A  complete  answer  to  the  demand  for  an  earlier  dis- 
position of  these  profits  is  that  the  purpose  of  organizing 
an  enterprise  which  includes  various  stages  of  manufacture 
may  be  assumed  to  be  the  expectation  of  producing  a  given 
article  in  complete  form  for  market  at  the  lowest  possible 
price,  and  it  is  expected  that  the  larger  the  number  of 
stages  which  are  covered  the  lower  will  such  cost  be.  This 
would  not  be  the  case  if  it  were  planned  to  take  credit  for 
a  series  of  profits  throughout  the  process  of  manufacture. 


PROFIT    AND    LOSS    ACCOUNT  213 

as   this   would   obscure   the  actual   cost    of   the   finished 
article. 

"Inter-Company  Profits" 

In  recent  years  there  has  been  a  tendency  toward  con- 
centration of  production,  and  the  same  problem  arises  with 
respect  to  intercompany  profits  as  with  interdepartmental 
profits.  This  subject  was  discussed  by  William  M.  Lybrand, 
C.P.A.,  in  his  paper  on  "The  Accounting  of  Industrial 
Enterprises,"  read  l^efore  the  American  Association  of 
Public  Accountants  at  Atlantic  City  in  1908.  He  said 
inter  alia : 

Some  of  the  industrial  enterprises  of  the  present  day  begin  their 
ownership  with  the  raw  materials  and  manufacture  their  output  all  the 
way  from  the  first  stage  to  the  last.  Necessarily  this  manufacturing 
cannot,  in  every  instance,  be  performed  in  one  continuous  operation 
or  by  one  plant,  and  there  will  be  constant  transfers  from  one  company 
to  another  of  product  finished  up  to  a  certain  point,  but  subject  to 
further  manipulation  in  order  that  it  may  be  disposed  of  in  a  different 
form.  At  the  end  of  the  fiscal  year  or  other  balance  sheet  period  there 
will  doubtless  be  a  quantity  of  such  merchandise  in  the  inventories  of 
the  several  subsidiary  companies,  purchased  by  one  company  from 
another  at  a  price  greater  than  the  actual  cost  of  manufacturing.  As 
the  companies  are  entirely  distinct  from  each  other,  it  may  be  argued 
that  the  purchasing  company  will  be  justified  in  including  such  mer- 
chandise in  its  inventory  at  the  price  paid  to  the  company  from  which 
it  was  acquired.  The  purchase,  however,  having  been  made  by  one 
subsidiary  company  from  another,  is  in  effect  merely  a  transfer  from 
department  to  department  of  virtually  the  same  corporation  and  not  a 
sale  on  which  profit  can  be  said  to  have  been  realized.  The  principle 
that  profits  must  not  be  anticipated  would  seem  therefore  to  be 
applicable  in  such  instances,  and  it  would  follow  that  a  reserve  should 
be  provided  equal  to  the  amount  by  which  such  merchandise  at  inter- 
company prices  exceeds  its  actual  manufacturing  cost. 

In  the  annual  report  of  the  United  States  Steel  Cor- 
poration for  1914  it  is  stated  that  these  intercompany  profits, 
which  formerly  were  segregated  as  part  of  the  surplus 
account,   but    included   among   the   inventories,    had   been 


214 


AUDITING 


eliminated  from  the  surplus  account  and  the  inventories  cor- 
respondingly reduced.    The  report  stated  that : 

Inventory  values,  as  above  stated,  are  on  the  basis  of  the  actual 
purchase  or  production  cost  of  the  materials  to  the  respective  subsidiary 
companies  holding  the  same  (unless  such  cost  was  above  the  market 
value  on  December  31,  1914,  in  w^hich  case  the  market  price  was  used) 
except  that  in  respect  of  such  commodities  in  stock  at  the  close  of  the 
year  as  had  been  purchased  by  one  subsidiary  company  from  another, 
there  has  been  excluded  the  approximate  amount  of  profits  in  such  sales 
price  which  had  accrued  to  the  subsidiaries  selling  the  same,  or  furnish- 
ing service  in  connection  therewith.  These  profits  are  not  carried  into 
the  currently  reported  earnings  of  the  entire  organization  until  con- 
verted into  cash  or  a  cash  asset  to  it.  Accordingly,  in  the  combined 
assets  for  all  of  the  companies,  the  inventories  of  those  materials  and 
products  on  hand  which  have  been  transferred  and  sold  from  one  sub- 
sidiary company  to  another,  are  carried  at  net  values  which  are  sub- 
stantially the  production  cost  to  the  respective  subsidiary  companies 
furnishing  the  same.  The  net  valuation  thus  obtained  and  stated  for 
the  total  inventories  of  all  materials  and  products  is  largely  below  the 
market  value  of  the  same. 

This  is  sound  and  conservative  accounting  and  should 
be  followed  by  every  corporation  which  desires  to  allow 
the  future  to  reap  the  benefit,  if  any,  of  future  transactions, 
rather  than  to  sell  goods  to  itself  at  a  profit. 

Sales  for  Future  Delivery 

As  mentioned  under  ''Work  in  Progress,"  it  is  customary 
in  many  lines  of  business  to  solicit  and  accept  orders  for 
future  delivery.  Where  the  expenses  of  taking  the  orders 
have  been  incurred  and  where  the  goods  themselves  are  on 
hand  ready  for  delivery,  it  may  seem  ultra-conservative  to 
advocate  waiting  for  actual  shipments  before  taking  credit 
for  the  profit  thereon.  Nevertheless,  this  practice  is  gen- 
erally followed  by  successful  concerns,  whereas  the  un- 
successful business  man,  in  his  attempts  to  bolster  up  a 
tottering  business,  usually  anticipates  every  profit  in  sight 
and  forgets  the  accrued  expenses. 


PROFIT    AND    LOSS    ACCOUNT 


215 


Theoretically  if  goods  have  been  sold  and  are  ready  for 
shipment  and  the  terms  of  the  order  permit  immediate 
shipment,  it  may  be  assumed  that  a  cause  of  action  has  so 
nearly  arisen  that  no  great  harm  could  follow  if  the  goods 
were  entered  as  a  sale,  accounts  receivable  were  debited,  and 
the  profit  and  loss  account  increased  by  the  profit.  But  every 
business  man  knows  that  up  to  the  instant  of  shipment,  and 
sometimes  afterwards,  cancellations  are  received  and  ac- 
cepted, or  a  fire  or  some  other  unexpected  occurrence  may 
operate  to  prevent  the  consummation  of  what  appeared  to 
be  a  sure  thing. 

In  the  annual  report  of  the  International   Harvester 

Company  for  1911  appears  the  following  comment  on  this 

point : 

Assuming  a  continuance  of  present  credit  methods  and  the  same 
proportion  of  forward  sales,  it  is  considered  advisable  to  gradually 
establish  a  contingent  reserve  for  deferred  profits  on  forward  sales. 
Theoretically  and  technically,  a  profit  is  earned  when  the  sale  is  made, 
but  when  the  actual  realization  of  the  profit  on  certain  sales  is  deferred 
a  considerable  time  beyond  the  close  of  the  fiscal  year,  it  is  obviously  a 
conservative  and  sensible  policy  to  establish  a  contingent  reserve  to 
meet  this  condition  inherent  in  the  business.  This  policy  prevents  the 
misleading  transfer  of  book  earnings  to  surplus,  where  a  long  period  of 
time  elapses  between  the  date  of  the  sale  and  the  realization  of  the 
profit  in  cash. 

The  balance  sheet  of  the  company  shows  a  reserve  for 
unrealized  profits  of  $2,500,000  which  has  been  accumulating 
for  some  years. 

The  conservative  business  man  does  not  and  will  not 
anticipate  the  profits  on  goods  ordered  but  not  shipped; 
the  conservative  auditor  will  not  certify  to  accounts  which 
are  prepared  on  any  such  basis.  * 

Participations  and  Underwritings 

During  recent  years  bankers  have  extended  the  privilege 
of  participating  with  themselves  in  underwritings  and  pur- 


2i6  AUDITING 

chases  to  a  considerable  number  of  investors  and  others. 
It  is,  therefore,  not  an  unusual  occurrence  to  see  some  ref- 
erence to  such  participation  in  books  of  account. 

Perhaps  a  majority  of  underwritings  yield  a  net  profit 
to  participants,  but  many  wind  up  with  a  loss.  Interim 
accounts  are  reports  of  progress  only  and  may  be  founded 
on  the  quotation  of  a  supported  market,  so  that  it  is  most 
unsafe  to  take  into  account  any  profit  at  all  until  it  is 
realized  in  cash. 

This  rule  applies  with  equal  force  where  securities  of 
a  new  corporation  are  distributed  as  a  bonus.  There  may 
be  a  market  price  in  effect  which  would  insure  a  handsome 
profit,  but  such  quotations  may  be  nominal  only.  The  sale 
of  a  part  of  the  participation  at  a  profit  on  the  purchase  price 
should  be  applied  against  the  entire  purchase  in  order  to 
write  down  its  book  cost.  This  is  based  on  the  same  gen- 
eral principle,  viz.,  that  the  market  may  be  a  fictitious  one 
and  not  to  be  depended  upon. 

Profit  on  Sale  of  Assets 

It  may  be  that  a  profit  has  been  reaHzed  on  the  sale  of 
a  portion  of  the  fixed  assets  of  a  concern.  Legally  this 
profit  may  be  carried  to  surplus  and  distributed  as  a  dividend, 
but  such  a  course  is  apt  to  create  a  false  impression  on 
stockholders.  It  is  much  better  to  carry  such  an  item  to  an 
account  whose  caption  indicates  the  character  of  the  entries 
therein,  and  which  may  be  carried  on  a  balance  sheet  as  a 
separate  section  of  the  surplus  account.  Under  such  cir- 
cumstances it  will  not  appear  to  be  applicable  to  dividend 
distributions  and  can  be  held  as  a  contingent  reserve  against 
possible  losses  on  other  capital  adjustments. 

Appreciation  in  Value  of  Assets 

It  has  been  intimated  elsewhere  in  this  book  that  ap- 
praisal companies  are  apt  to  certify  to  valuations  in  excess 


PROFIT    AND    LOSS    ACCOUNT  2] 

of  book  figures.  It  must  be  said  in  favor  of  these  com- 
panies that  they  seem  to  carry  on  their  appraisals  in  a 
careful  and  conscientious  manner  and  it  may  be  that 
the  rise  in  the  prices  of  materials  and  labor  during  the 
last  ten  or  fifteen  years  justifies  their  apparent  over- 
valuations. 

It  is  stated  on  good  authority  that  the  costs  of  building 
material  and  labor  have  increased  about  25  per  cent  during 
the  last  ten  years,  and  machinery  from  5  per  cent  to  10  per 
cent  during  the  same  period. 

Unfortunately  many  business  men  who  secure  an  ap- 
praisal which  sets  forth  that  their  buildings  and  machinery 
are,  on  the  basis  of  a  replaceable  valuation  less  depreciation, 
worth  more  than  they  cost  originally,  wish  to  set  up  on  their 
books  and  statements  this  diagnosis,  and  do  not  like  to  be 
told  that  they  are  making  trouble  for  themselves.  They 
have  a  larger  valuation  to  wipe  out  by  depreciation  reserves, 
and  thus,  in  a  sense,  they  are  increasing  their  cost  of  pro- 
duction. After  a  credit  to  surplus  account  is  once  made  it 
is  most  unlikely  that  any  part  thereof  will  be  used  except  for 
dividends. 

The  law  on  the  subject  of  profits  is  not  well  settled  and 
will  not  be,  so  long  as  the  majority  of  lawyers  retain  their 
profound  ignorance  of  accounts,  but  it  is  quite  likely  that 
no  legal  obstacle  would  prevent  a  corporation  from  revaluing 
part  of  its  assets  and  applying  the  excess  so  raised  to  surplus 
available  for  dividends.  With  the  law  in  such  an  unsatis- 
factory condition  it  remains  for  the  professional  auditor  to 
educate  the  business  public  to  the  principle  that  it  is  not 
only  foolhardy  but  unscientific  to  write  up  the  value  of  an 
asset  which  is  not  for  sale  and  which  therefore  cannot  be 
represented  by  cash  or  its  equivalent.  Funds  for  dividends 
should  be  realized  from  the  earnings,  otherwise  the  work- 
ing capital  of  the  company  is  permanently  depleted  if  a  cash 


2i8  AUDITING 

dividend  is  declared  out  of  surplus  created  in  the  manner 
stated. 

There  may  be  in  exceptional  cases  an  obvious  rise  in 
value  of  an  item  of  fixed  assets,  but  a  footnote  on  the  balance 
sheet  is  all  that  is  required  to  secure  the  benefit  of  an  in- 
creased credit  rating,  and  any  adjustment  of  the  account  in 
the  books  by  increasing  the  asset  and  crediting  surplus  is 
rarely  permitted  by  good  accounting  practice. 

Professional  auditors  should  interest  themselves  in  the 
corporation  laws  of  their  respective  states  and  assist  in  the 
enactment  of  statutes  comprehensive  enough  to  cover  the 
points  just  discussed. 


CHAPTER    XI 

PROFIT  AND  LOSS  ACCOUNT    (Continued) 


EXPENSES   AND   LOSSES 

The  several  accounts  which  include  in  more  or  less  detail 
the  charges  against  or  deductions  from  the  earnings  of  an 
enterprise  are  fully  described  in  Chapter  >5VI,  "The  Detailed 
Audit — Purchases  and  Expenses."  There  are,  however, 
some  accounts  which  do  not  arise  out  of  cash  transactions 
and  others  about  which  more  can  be  said.  These  accounts 
will  now  have  our  attention. 

Reserves 

We  have  discussed  on  other  pages  the  following  reserve 
accounts : 

Bad  accounts,  page  371. 
Accrued  expenses,  page  225.  C 
Depreciation,  exhaustion,  etc..  Chapter  XVIIlJT 
Obsolescence,  page  224.  )f^ 
Contingencies,  page  168.  ^  ^         ^ 

Sinking  fund  accounts,  pages  128)  194.} 
The  question  now  arises  as  to  how  and  when  these  charges 
should  appear  in  a  current  profit  and  loss  account.     The 
fact  is  that  they  do  not  as  a  rule  appear  in  the  current  profit 
and  loss  account  at  all. 

A  fair  proportion  of  the  10  per  cent  of  the  business 
enterprises  of  this  country  who  do  consult  professional  ac- 
countants heed  the  advice  given  and  include  among  their 
expenses,  or  deductions  from  income,  all  of  the  costs  of 
doing  business,  and  the  words  "net  profit"  are  not  used 

219 


220  AUDITING 

except  after  full  allowance  has  been  made  for  keeping  the 
capital  intact.  Most  of  the  remaining  90  per  cent,  and  those 
who  consult  but  who  do  not  heed  the  professional  auditor, 
however,  include  among  their  earnings  every  dollar  of  pos- 
sible income,  but  from  such  earnings  are  deducted  only 
such  costs  and  expenses  as  are  apparent  and  easily  ascer- 
tained, the  balance  being  designated  as  ''net  profit."  This 
balance  is  carried  to  surplus  and  is  thereafter  referred  to  as 
the  profit  earned  during  the  period  stated.  Subsequently 
(but  only  if  the  period  has  been  a  prosperous  one)  various 
deductions  are  made  from  surplus,  covering  depreciation, 
adjustment  of  inventories,  writing  off  of  accounts  re- 
ceivable, etc. 

This  practice  seems  hopeless  to  the  auditor  who  is 
familiar  with  actual  conditions  and  who  knows  that  about 
99  per  cent  of  such  deductions  were  direct  charges  against 
earnings  and  that  most  of  the  items  could  have  been  in- 
cluded in  the  current  profit  and  loss  statements.  But  busi- 
ness men  will  fool  themselves,  and  corporation  officers  and 
directors  will  fool  their  stockholders,  and  attempt  to  fool 
the  public.  However,  a  slight,  but  perceptible,  progress  is 
being  made,  and  it  is  inevitable  that  some  day  the  words 
"net  profit"  will  have  the  same  meaning  as  the  word 
"sterling"  on  silver.  Laws  and  custom  w^ill  decree  that  the 
issuing  of  false  statements  such  as  are  now  spread  broad- 
cast will  be  a  punishable  offense. 

It  is  regrettable  but  true  that  many  financial  writers  of 
ability  who  should,  and  perhaps  do,  know  better,  are  re- 
sponsible for  much  of  the  present  unsatisfactory  state  of 
affairs  in  this  respect.  Just  as  surely  as  a  corporation  does 
issue  a  carefully  prepared  balance  sheet  and  profit  and  loss 
statement,  probably  one  certified  to  by  reputable  auditors,  in 
which  proper  deductions  are  made  to  cover  the  items  here- 
tofore referred' to,  one  or  more  of  these  writers  will  learnedly 


PROFIT    AND    LOSS    ACCOUNT  221 

analyze  its  contents  for  the  edification  of  the  investing  public. 
Almost  invariably  they  will  ignore  the  deductions  for  depre- 
ciation, etc.,  and  solemnly  state  that  during  the  period  the 
corporation  "earned"  a  given  per  cent  on  the  capital — 
carrying  out  the  rate  to  several  decimal  places.  They  may 
mention  incidentally  that  from  the  profits  there  were  certain 
deductions,  thus  emphasizing  their  own  opinion  that  the 
actual  profit  was  the  one  used  as  a  basis  for  calculating  the 
rate  earned,  and  that  the  deductions  were  purely  voluntary. 

When  legislative  investigations  are  instituted,  these 
figures  are  also  the  ones  used,  and  the  fallacy  has  been  car- 
ried so  far  that  some  corporations  that  have  not  and  never 
can  earn  a  dividend  on  their  common  stocks  are  cited  as 
having  realized  large  earnings.  In  the  case  of  the  United 
States  Steel  Corporation  nearly  all  of  the  financial  writers, 
and  certainly  all  of  the  statesmen  (?),  who  have  investi- 
gated its  affairs  state  its  net  earnings  over  a  period  of  years 
as  many  millions  of  dollars  greater  than  the  accounts  of  the 
corporation  itself  show. 

What  is  the  real  trouble  ?  Surely  accurate  accounts 
are  desired.  Is  it  because  the  tendency  to  overstate  profits 
and  understate  losses  is  so  general  among  business  men 
that  no  standard  exists  ? 

Perhaps  public  accountants  are  themselves  somewhat  to 
blame  for  present  conditions.  Have  they  always  been  keen 
to  make  all  the  deductions  of  which  they  have  any  knowledge 
from  earnings  before  designating  any  one  sum  as  ''net 
profit"? 

The  fact  is  that,  because  some  of  the  reserves  for  de- 
preciation, etc.,  are  more  or  less  difficult  to  ascertain,  it  has 
been  fairly  general  to  omit  them  entirely,  or  qualify  the 
account  by  stating  that  the  profits  are  so  and  so  exclusive 
of  some  very  large  costs  and  expenses.  Is  it  not  peculiar 
that  this  action  on  the  part  of  the  auditor  exactly  fits  in  with 


222  AUDITING 

the  wishes  of  the  client  who  knowingly  overstates  his 
profits  ?  Candidly,  is  it  not  possible  to  estimate  more  closely 
on  an  allowance  for  depreciation  than  on  the  valuations  of 
fixed  assets  or  current  inventories  to  which  the  auditor  so 
cheerfully  certifies  ? 

Depreciation 

The  question  of  depreciation  is  important  enough  to 
require  an  entire  chapter  for  its  discussion  (see  Chapter 
XVIII),  but  at  this  point  it  is  in  order  to  consider  whether 
or  not  depreciation  is  to  be  included  among  the  cost  and 
expense  items  in  the  current  profit  and  loss  account. 

In  the  preceding  section  attention  was  called  to  the  gen- 
eral practice  of  omitting  this  and  other  items  from  ordinary 
operating  accounts.  Accountants  of  experience  defend  this 
practice  on  the  ground  that  where  depreciation  has  not  been 
calculated  at  all,  or  where  an  arbitrary  amount  has  been  set 
aside,  the  task  of  determining  a  fair  allowance — one  that 
can  be  included  among  operating  costs  without  detracting 
from  the  value  of  the  entire  statement — is  too  onerous  to 
handle,  with  the  result  that  costs  are  compiled  without  any 
allowance  for  depreciation.  It  is,  of  course,  assumed  that 
mention  is  made  of  the  omission  before  any  final  figures  are 
certified  to. 

It  will  always  be  admitted  that  wear  and  tear,  and  per- 
haps obsolescence,  is  going  on  all  the  time.  If  not  admitted 
in  so  many  words,  the  repairs  and  maintenance  accounts 
speak  for  themselves.  The  usual  and  time-worn  argument 
against  provision  for  deterioration  is  that  constant  attention 
is  given  to  the  upkeep  of  the  plant  and  renewals  and  repairs 
are  looked  after  as  soon  as,  or  before,  occasion  demands. 

Disregarding  for  the  moment  the  fact  that  there  is 
always  a  considerable  amount  of  accrued  wear  and  tear  not 
apparent  enough  to  necessitate  immediate  attention,  there 


PROFIT    AND    LOSS    ACCOUNT 


223 


is  to  be  considered  the  question  whether  the  renewals  and 
repairs  which  will  be  imperative,  and  which  are  always  in- 
cluded among  the  expenses  or  costs,  recur  regularly  enough 
to  be  charged  up  as  incurred  without  upsetting  the  equilib- 
rium of  the  accounts,  or  whether  in  the  ordinary  course  of 
affairs  the  amounts  fluctuate  so  greatly  that  factory  man- 
agers are  justified  in  leaving  the  items  out  of  consideration 
in  self-defense,  as  otherwise  their  costs  would  vary  to  such 
an  extent  that  comparative  records  would  be  ludicrous. 

In  the  case  of  fuel,  for  example,  no  such  difficulty  arises. 
Purchases  and  consumption  run  along  regularly  and  no  one 
would  think  of  omitting  the  cost  thereof.  Now  wherein 
lies  the  essential  difference  between  the  cost  of  fuel  con- 
sumed under  a  boiler  and  the  accruing  loss  on  the  purchase 
price  of  the  boiler  itself?  Both  are  consumed  in  the  process 
of  manufacturing.  The  cost  of  both  must  be  reimbursed 
from  the  proceeds  of  the  sale  of  the  product  manufactured, 
or  the  capital  of  the  concern  will  be  depleted.  Capital  de- 
pletion is  exactly  what  happens  in  thousands  of  cases.  The 
cost  of  fuel  is  made  a  part  of  the  cost  of  the  product,  but 
for  some  mysterious  reason  the  cost  of  the  boilers  is  pro- 
vided in  some  other  way,  or  at  least  that  is  the  effect  of  the 
accounting  system  followed. 

The  most  flagrant  fallacy  is  found  in  connection  with 
the  accounts  of  the  first  year's  operations  of  a  new  plant. 
The  management,  if  sane,  must  know  that  the  buildings  and 
machinery  will  not  last  forever  and  that  into  every  unit 
of  production  there  has  gone  some  part  of  the  entire  cost 
of  the  plant.  It  would  be  ridiculous  to  charge  the  total  cost 
of  buildings  and  machinery  into  the  operations  of  the  first 
year,  but  is  it  not  equally  unsound  to  make  no  charge 
whatever  thereto  merely  because  the  exact  amount  of  the 
charge  is  somewhat  difficult  to  ascertain? 

Accounting  difficulties  are  comparative  only,  and  accurate 


224  AUDITING 

accounts  always  require  careful  and  intelligent  attention. 
If  the  same  thought  were  given  to  calculating  the  proper 
proportion  of  the  cost  of  a  boiler,  which  forms  a  part  of 
the  cost  of  operation,  as  is  given  to  determining  the  basic 
costs  of  other  elements  which  enter  into  the  manufacturing 
operations  of  a  modern  plant,  the  amount  arrived  at  would 
be  quite  close  enough  to  form  a  dependable  item  of  prime 
cost. 

Professional  auditors  fail  in  their  duty  whenever  they 
allow  an  opportunity  to  pass  which  might  permit  them  to 
elucidate  the  foregoing  principle.  Thousands  of  enterprises 
have  gone  into  bankruptcy  solely  because  their  accounts 
never  exhibited  the  full  cost  of  their  product.  As  soon  as  ac- 
counting practice  and  procedure  and  commercial  common 
sense  are  developed  to  the  point  where  an  allowance  for 
depreciation  is  made  just  as  much  a  part  of  prime  cost  as 
labor  or  materials,  a  considerable  number  of  business  failures 
Vv^ill  be  prevented. 

Obsolescence 

The  author  is  not  prepared  at  this  time  to  support  the 
contention  that  an  allowance  for  obsolescence  is  an  item  of 
prime  cost  as  is  the  case  with  depreciation.  The  latter 
is  certain  and  cannot  be  avoided  any  more  than  taxes 
or  death. 

Obsolescence  is  never  certain.  It  is  true  that  most  of  our 
modern  machinery  has  superseded  other  machinery  which 
was  not  worn  out,  and  the  plant  of  ten  years  ago  which 
counted  on  a  twenty-year  life  for  its  equipment  and  set  up 
a  depreciation  reserve  on  that  basis  has  not  been  able  to 
renew  that  machinery  out  of  the  reserve. 

Take  the  case  of  a  machine  costing  $1,000  in  1908  with 
an  estimated  life  of  fifteen  years  and  a  scrap  value  of  $100. 
There  would  have  been  $900  to  charge  to  operations  and  a 


PROFIT    AND    LOSS    ACCOUNT 


225 


depreciation  reserve  based  on  the  expected  life  would  be 
conservative  accounting.  In  1915  it  is  found  that  the 
machine  is  obsolete  and  a  new  one  costing  $1,500  is  pur- 
chased, but  the  new  one  has  twice  the  capacity  of  the  old. 
Here  we  find  our  answer  to  a  large  extent.  An  old  machine 
will  not  be  superseded  by  a  new  one  unless  the  latter  has 
greater  efficiency  or  capacity,  and  this  supplies  authority  for 
capitalizing  part  of  the  cost  of  the  new  machine. 

It  is  obvious  that  obsolescence  cannot  be  foreseen,  and 
any  attempt  to  reduce  the  contingency  to  a  definite  allow- 
ance to  form  part  of  current  operating  costs  would  defeat 
its  own  purpose.  In  view  of  the  rapid  strides  in  all  of  the 
mechanical  sciences,  obsolescence  is  likely  to  continue  to  be 
a  serious  factor  in  the  ultimate  cost  of  producing  manu- 
factured goods.  Therefore,  wherever  possible,  a  reserve 
should  be  created  to  meet  the  possibility,  but  the  reserve 
should  be  provided  for  out  of  profits  before  stating  the 
surplus  applicable  to  dividends  and  never  as  an  item  of 
prime  cost. 

Accrued  Expenses,  etc. 

It  is  perhaps  superfluous  to  mention  that  the  items  of 
expenses  in  a  profit  and  loss  account  embrace  those  which 
have  accrued  during  the  period,  whether  paid  for  or  not. 
At  the  closing  date  all  accrued  expenses,  rents,  taxes,  in- 
terest, and  similar  items  should  be  ascertained  and  entered 
as  liabilities  on  one  side  and  charged  to  their  respective^ 
expense  accounts  on  the  other. 

As  many  of  these  expenses  are  more  or  less  unusual  in 
their  nature,  it  seems  unavoidable  that  some  are  omitted. 
The  question  then  arises  in  subsequent  audits  as  to  whether 
the  items  applying  to  prior  periods  should  be  charged  to 
surplus  or  included  among  the  current  expenses  of  the 
period  in  which  paid.     There  are  two  reasons  in  favor  of 


226  AUDITING 

the  latter  practice  and  no  good  reason  in  favor  of  the 
former.  In  the  first  place,  where  charges  are  made  against 
an  old  book  surplus  it  simply  means  that  so  far  as  pub- 
lished accounts  go  they  are  never  in  evidence.  That  is,  the 
items  were  not  known  at  the  time  and  were  therefore 
omitted  from  the  period  in  which  they  belonged,  and  being 
eliminated  from  the  period  in  which  paid  they  practically 
disappear. 

The  most  valuable  records  compiled  are  comparative 
schedules  of  earnings  and  expenses,  and  where  these  are 
carried  along  from  year  to  year  it  is  practically  impossible 
to  adjust  reports  which  are  perhaps  a  year  old  and  of  which 
frequent  use  has  been  made.  Therefore  proper  accounting 
practice  permits  the  inclusion  of  such  items  in  the  current 
profit  and  loss  account,  without  calling  special  attention  to 
the  matter,  unless  the  items  are  large  enough  to  alter 
materially  the  results,  in  which  case  the  items  are  deducted 
from  the  net  profit  of  the  current  year  before  a  transfer 
to  surplus  is  made.  Where  the  items  are  comparatively 
small  it  may  be  assumed  that  corresponding  items  are 
omitted  from  the  current  accounts  and  will  have  to  be 
taken  care  of  in  the  subsequent  period. 

This  must  not  be  construed  as  an  excuse  for  closing  ac- 
counts before  every  known  liability  is  taken  into  considera- 
tion. The  auditor  who  does  not  satisfy  himself  that  all 
known  liabilities  and  those  which  should  be  known  are  in- 
cluded in  a  balance  sheet  is  guilty  of  negligence  and  de- 
serves any  consequence  which  may  ensue. 

Cash  Discounts 

Where  it  is  customary  to  permit  trade  debtors  to  de- 
duct a  discount  for  cash  within  a  limited  period  these 
deductions  are  entered  in  a  separate  column  of  the  cash  book. 
The  discount  allowed  up  to  the  date  of  the  closing  will,  of 


PROFIT    AND    LOSS    ACCOUNT 


227 


course,  appear  in  the  books,  preferably  in  a  separate  ledger 
account. 

The  aggregate  of  such  allowances  should  be  entered 
among  the  expenses  of  the  business  and  not  as  a  direct  de- 
duction from  gross  earnings.  The  theory  is  that  the  dis- 
count allowed  represents  a  premium  paid  for  prompt  atten- 
tion and  for  the  use  of  the  money  at  an  earlier  date  than 
it  w^ould  be  received  if  no  inducement  were  made  for  pre- 
payment. Where  the  items  are  strictly  cash  discounts,  and 
are  not  permitted  if  the  debtor  does  not  pay  within  the  limit, 
then  the  total  allowance  is  clearly  an  expense  and  should 
not  be  charged  against  sales  as  if  it  represented  an  abate- 
ment of  the  purchase  price  of  the  goods. 

Trade  Discounts 

The  author,  in  common  with  most  practitioners,  has  al- 
ways stated  that  trade  discounts  were  direct  deductions  from 
invoices  and  should  not  appear  in  the  books  of  account  of 
the  seller  or  the  purchaser. 

It  is  true,  however,  that  in  some  trades  considerable 
importance  is  placed  upon  the  variations  in  trade  dis- 
counts, and  it  would  seem  to  be  in  order  that  the  accountancy 
student  should  be  given  an  opportunity  to  decide  for  him- 
self whether  trade  discounts  have  any  place  in  books  of 
account.  This  point  assumes  importance  in  auditing  be- 
cause the  auditor  cannot  very  well  report  the  amount  of 
trade  discounts  given  or  received  unless  the  items  have  been 
separated  throughout  the  period  covered  by  the  profit  and 
loss  account. 

At  the  request  of  the  author  the  "case"  for  trade  dis- 
counts was  stated  by  John  R.  Wildman,  C.P.A.,  as  follows : 

The  general  practice  is  to  deduct  trade  discounts  from  the  face 
of  the  purchase  and  sales  invoices.  It  is  claimed,  however,  that  in  large 
organizations,  where  the  fixing  of  prices  is  delegated  by  the  administra- 


228  AUDITING 

tive  officers  to  the  respective  heads  of  purchasing  and  sales  depart- 
ments, the  recording  of  the  data  in  question  facilitates  the  compilation 
of  statistics  which  will  show  the  average  discounts  and  thus  serve  some- 
what as  an  index  to  the  efficiency  of  the  heads  of  the  respective  depart- 
ments as  well  as  to  serve  as  a  guide  to  the  administrative  officers  in 
reaching  conclusions  and  formulating  policies  concerning  these  phases 
of  the  business. 

Theoretically,  it  appears  to  have  some  scientific  foundation.  Prac- 
tically, it  is  questionable  whether  the  amount  of  work  involved  is  war- 
ranted by  the  purpose  for  which  the  data  are  used. 

Accounting  instruction,  in  my  opinion,  should  be  as  broad  as  pos- 
sible. Every  phase  of  a  subject  should  be  discussed.  All  the  facts 
should  be  presented.  The  relative  advantages  and  disadvantages  of 
various  methods  should  be  explained.  After  discussion  the  instructor 
should  state  the  preference  dictated  by  the  general  practice  so  far  as 
it  can  be  ascertained.  Further,  the  relation  of  trade  discounts  to  cash 
discounts,  and  the  relation  of  both  to  the  purchase  and  sales  prices, 
seem  worthy  of  discussion. 

DISPOSITION  OF  PROFIT 

When  an  auditor  has  determined  the  amount  which  he 
is  wiHing  to  certify  represents  "net  profit,"  the  difficult  part 
of  his  task  is  completed.  Probably  he  will  not  be  asked 
whether  the  amount  shown  should  be  paid  out  in  dividends 
or  transferred  to  surplus,  and  as  a  matter  of  principle  he  is 
not  concerned.  It  may  be,  however,  that  his  opinion  will 
be  asked,  in  which  event  he  may  be  able  to  suggest  such  a 
disposition  of  the  profit  as  will  conserve  the  best  interests  of 
the  concern. 

Whether  to  declare  a  cash  or  a  stock  dividend  is  a  ques- 
tion which  may  very  properly  be  referred  to  the  auditor. 
There  should  be  no  transfer  of  profits  to  general  surplus 
account  unless  the  entire  amount  is  applicable  to  dividends 
when  and  if  declared.  The  net  profit  for  the  period  is  first 
shown,  then  any  transfers  which  have  been  authorized  by 
the  board  are  deducted,  the  balance  being  carried  to  surplus. 
This  practice  has  been  followed  by-  some  of  our  best- 
managed  corporations  for  a  number  of  years,  and  has  the 


PROFIT    AND    LOSS    ACCOUNT  22g 

sanction  of  law  in  that  the  courts  have  repeatedly  held  that 
the  directors  of  a  corporation  need  not  declare  dividends 
unless  they  so  desire,  provided  they  can  show  that  the  funds 
which  would  be  required  for  dividend  disbursements  can 
be  used  to  better  advantage  in  the  business. 

It  is  carrying  this  discretion  to  an  extreme  which  stock- 
holders never  contemplate  when  they  purchase  stock,  for 
the  directors  to  invest  the  surplus  in  securities  the  control 
of  which  is  not  a  necessary  incident  to  the  carrying  on  of 
the  business  for  which  the  corporation  was  organized. 

In  England  the  law  is  as  follows : 

English  Companies  (Consolidation)  Act  1908.  Table  A.  Section 
99.  The  directors  may,  before  recommending  any  dividend,  set  aside 
out  of  the  profits  of  the  company  such  sums  as  they  think  proper  as  a 
reserve  or  reserves  which  shall,  at  the  discretion  of  the  directors,  be 
applicable  for  meeting  contingencies,  or  for  equalizing  dividends,  or  for 
any  other  purpose  to  which  the  profits  of  the  company  may  be  properly 
applied,  and,  pending  such  application,  may,  at  the  like  discretion, 
either  be  employed  in  the  business  of  the  company  or  be  invested  in 
such  investments  (other  than  shares  of  the  company)  as  the  directors 
may  from  time  to  time  think  fit. 

An  auditor  will  recommend  the  setting  aside  of  reserves 
for  contingencies  or  for  the  equalization  of  dividends  or 
other  reasonable  purposes  so  long  as  the  financial  condition 
of  a  corporation  demands  conservative  financing,  but  when  it 
finds  itself  so  well  off  that  it  can  not  only  pay  all  of  its 
debts,  but  has  cash  enough  to  purchase  investment  securities, 
then  the  auditor  had  better  allow  the  board  itself  to  take  all 
the  responsibility.  The  practice  savors  too  much  of  paternal- 
ism. Stockholders  are  said  to  forget  dividends  quickly,  and 
it  is  therefore  not  thought  safe  to  pay  out  big  dividends  in 
good  years  and  small  or  no  dividends  in  poor  years.  But 
some  stockholders  are  quite  as  well  qualified  as  the  directors 
to  invest  their  earnings  and  prefer  some  variation  in  the 
dividend  rate  to  an  attempt  to  build  up  a  big  surplus  and 


230 


AUDITING 


indefinitely  postpone  the  distribution  of  the  earnings  of  a 
particularly  prosperous  period. 

PRINCIPAL  AND  INCOME 

It  has  been  pointed  out  in  other  chapters  of  this  book 
that  the  distinction  between  principal  and  income  (or  capital 
and  revenue)  must  ever  be  in  the  auditor's  mind.  It  affects 
the  balance  sheet  as  well  as  the  profit  and  loss  account  and 
is  a  fact  to  be  faced  rather  than  a  theory  to  be  played  with. 

As  the  matter  is  discussed  fully  under  various  headings, 
it  is  not  necessary  here  to  review  the  attitude  of  the  auditor 
with  respect  to  determining  whether  a  given  item  belongs 
to  principal  or  to  income,  because  by  reason  of  his  training 
and  experience  he  will  decide  each  question  according  to 
its  merits,  with  sound  accounting  principles  to  guide  him. 
It  is  at  present  doubtful,  however,  whether  the  courts  can 
be  depended  upon  to  decide  as  equitably. 

Dividends  Must  Not  be  Paid  from  Capital 

While  questions  with  respect  to  capital  and  revenue " 
arise  in  every  branch  of  accounts,  many  of  them  are  not 
met  squarely,  but  are  passed  over  undecided.  Issue  is  not 
usually  joined  until  the  question  of  a  dividend  arises. 
Directors  and  managers  who  will  not  admit  that  depreciation 
is  an  operating  expense  will  nevertheless  hesitate  before 
voting  for  or  advocating  the  payment  of  a  dividend  before 
there  have  been  set  aside  sufficient  reserves  to  maintain  the 
capital  intact. 

Section  23  of  the  New  York  Stock  Corporation  Law 
provides : 

The  directors  of  a  stock  corporation  shall  not  make  dividends, 
except  from  the  surplus  profits  arising  from  the  business  of  such  cor- 
poration ;  nor  divide,  withdraw,  or  in  any  way  pay  to  the  stockholders, 
or  any  of  them,  any  part  of  the  capital  of  such  corporation,  or  reduce 


PROFIT    AND    LOSS    ACCOUNT 


231 


its  capital  stock,  except  as  authorized  by  law.  In  case  of  any  violation 
of  the  provisions  of  this  section,  the  directors  under  whose  administra- 
tion the  same  may  have  happened,  except  those  who  may  have  caused 
their  dissent  therefrom  to  be  entered  at  large  upon  the  minutes  of  such 
directors  at  the  time,  or  were  not  present  when  the  same  happened, 
shall  jointly  and  severally  be  liable  to  such  corporation  and  to  the 
creditors  thereof  to  the  full  amount  of  the  capital  of  such  corporation 
so  divided,  withdrawn,  paid  out,  or  reduced. 

The  English  Companies  (Consolidation)  Act,  1908,  con- 
tains the  following  provisions  relative  to  dividends : 

Table  A.  Section  95.  The  company  in  general  meeting  may  declare 
dividends,  but  no  dividend  shall  exceed  the  amount  recommended  by 
the  directors. 

Section  96.  The  directors  may  from  time  to  time  pay  to  the  mem- 
bers such  interim  dividends  as  appear  to  the  directors  to  be  justified  by 
the  profits  of  the  company. 

Section  97.    No  dividend  shall  be  paid  otherwise  than  out  of  profits. 

There  is  no  practical  difference  between  this  law  and 
that  of  New  York  State.  In  neither  jurisdiction  is  it  per- 
missible to  pay  a  dividend  unless  the  capital  is  unimpaired. 
Where  the  assets  have  depreciated  in  value  and  the  depre- 
ciation is  not  provided  for  out  of  earnings,  the  capital  is 
impaired. 

In  the  case  of  the  Interborough-Metropolitan  Company, 
of  New  York,  its  losses  in  respect  of  holdings  in  the  Metro- 
politan Street  Railway  were  so  great  as  to  cause  a  very  large 
deficit.  In  some  states  it  has  been  held  that  yearly  profits 
may  be  distributed  irrespective  of  shrinkage  in  capital  assets, 
but  in  New  York  the  question  has  not  been  judicially  de- 
termined. Recent  earnings  of  the  Interborough-Metropol- 
itan Company  arising  out  of  its  holdings  of  profitable 
subsidiaries  have  been  large  enough  to  justify  dividends; 
but  it  was  considered  unwise  to  pay  dividends  so  long  as 
the  large  deficit  remained.  Thereupon  the  Interborough- 
Metropolitan  Company  consolidated  with  a  new  company 


232  AUDITING 

which  had  a  much  smaller  capitalization,  and  upon  the  ex- 
change of  the  stock  of  the  old  company  for  the  new  the 
latter  immediately  commenced  the  payment  of  dividends. 

There  are  undoubtedly  many  corporations  in  existence 
today  whose  dividends  are  being  or  have  been  paid  out  of 
capital.  If  stockholders  appreciated  their  rights,  many  di- 
rectors would  be  called  to  account  for  this. 

The  most  notable  case  in  the  United  States  wherein  it 
was  shown  that  dividends  were  paid  out  of  capital  instead 
of  net  profits  or  surplus  is  the  American  Malting  case.  If 
an  auditor  finds  himself  in  disagreement  with  a  board  of 
directors  over  the  allocation  of  items  to  capital  or  revenue 
he  may  find  it  salutary  to  request  them  to  read  extracts 
from  this  case. 

Decedents'  Estates 

The  distinction  between  principal  and  income  assumes 
more  importance  in  some  trust  estates  than  in  ordinary  com- 
mercial practice,  because  while  with  the  latter  the  result  of 
a  misapplication  of  an  item  may  affect  the  ultimate  solvency 
of  an  enterprise,  in  respect  to  an  estate  the  decision  of  a 
court  as  to  a  dividend  being  principal  or  income  may  actually 
deprive  a  dependent  of  the  necessities  of  life. 

Wasting  Assets 

It  is  permissible  for  a  mining  company  to  pay  out  in 
dividends  all  realizations  from  its  operations,  but  its  stock- 
holders are  on  notice  that  the  capital  of  the  company  is 
being  dissipated.  On  the  other  hand,  if  a  steel  company 
owns  ore  lands  it  must  not  treat  the  entire  net  income  from 
ore  sales  as  profit,  but  is  obliged  to  allocate  the  realizations 
into  principal  and  income.  The  principal  must  Idc  kept  intact 
in  order  that  the  capital  may  not  be  depleted.  The  income 
may  be  distributed  in  dividends. 


PROFIT    AND    LOSS    ACCOUNT  233 

In  an  estate  the  practice  (in  the  absence  of  testamentary 
or  statutory  provisions  to  the  contrary)  is  similar  to  that 
of  mining  companies,  that  is,  the  tenant  for  life  may  work  a 
mine  or  a  quarry  or  cut  down  timber  and  is  not  required  to 
make  good  the  depletion.  In  the  case  of  buildings,  etc., 
the  rule  is  different;  they  must  be  maintained,  ordinary 
wear  and  tear  excepted. 

Interest 

Interest  and  similar  income  is  said  to  accrue  from  day  to 
day  so  that  the  full  amount  accrued  to  the  date  of  the  dece- 
dent's death  becomes  principal. 

It  has  been  held  in  at  least  one  state  that  where  the  in- 
terest is  represented  by  a  coupon  the  amount  thereof  is  not 
apportionable,  but  represents  a  separate  contract  to  pay  a 
definite  amount  at  a  certain  time.  The  distinction  between 
such  a  contract  and  a  registered  bond,  where  the  interest 
is  paid  by  check  and  is  not  represented  by  coupons,  is  a  fine 
one,  rather  beyond  the  comprehension  of  a  layman. 

Dividends 

The  date  of  the  declaration  of  a  dividend  fixes  its 
standing  as  principal  or  income;  if  declared  before  the  dece- 
dent's death  it  is  principal,  even  though  it  is  payable  after 
the  date  of  death.  It  accrues  wholly  on  the  date  of  declara- 
tion, i.e.,  there  is  no  apportionment  based  on  the  period  it 
covers. 

Stock,  and  Extraordinary  Cash  Dividends 

The  foregoing  rule  does  not  always  apply  to  dividends 
which  are  declared  out  of  the  regular  order.  It  is  rather 
popular  for  corporations  and  banks  to  accumulate  their 
excess  earnings  for  a  long  period  of  years  and  then  make 
an  extraordinary  distribution  at  one  time,  in  cash  or  in  stock. 


234 


AUDITING 


In  most  cases,  and  in  all  cases  where  full  and  correct  ac- 
counts have  been  published  periodically,  these  hoarded  earn- 
ings become  identified  with  the  capital  of  the  undertaking, 
and  furthermore  are  reflected  in  the  market  price  of  the 
stock. 

From  an  accountant's  point  of  view  it  seems  absurd  that 
a  life  tenant,  to  whom  there  is  devised  the  income  for  life 
on,  say,  ten  shares  of  stock,  should  receive  as  income,  say, 
ninety  shares  of  the  same  stock,  thus  vitally  depreciating 
the  estate  left  for  the  remainderman.  But  the  courts  have 
so  held  in  spite  of  the  injustice  of  the  result.  In  some  juris- 
dictions, however,  the  decisions  have  been  to  the  effect  that 
extraordinary  dividends  are  distributions  of  principal. 

Space  does  not  permit  a  lengthy  discussion  of  this  sub- 
ject. Any  one  interested  and  seeking  further  particulars 
is  referred  to  a  very  able  and  interesting  paper  on  the 
subject  by  William  F.  Weiss,  C.P.A.,  of  New  York. 


CHAPTER    XII 

CERTIFICATES    AND    REPORTS 

What  shall  it  benefit  an  auditor  if  he  perform  the  highest 
grade  of  professional  work  and  be  unable  to  present  his  re- 
sults in  a  form  acceptable  to  and  understandable  by  his 
client?  Yet  this  happens  every  day,  chiefly  because  some 
auditors  apparently  prepare  reports  for  themselves  rather 
than  for  those  they  are  supposed  to  enlighten.  An  engineer 
builds  a  bridge  for  others  to  use.  It  is  useless  unless  it  is 
safe  and  convenient.  The  man  who  rides  across  it  does 
not  care  how  many  difficult  problems  were  encountered  in 
the  building,  nor  how  they  were  solved ;  he  is  content  to 
judge  the  engineer  by  results.  So  with  a  banker  or  a  busi- 
ness man.  He  employs  an  auditor  because  he  wants  re- 
sults, and  he  wants  results  which  he  can  use  without  having 
to  follow  in  the  auditor's  footsteps  and  traverse  the  same 
jungles  of  figures  and  grapple  with  the  same  problems 
through  which  the  results  were  accomplished. 

As  pointed  out  in  Chapter  III,  the  auditor  should  pre- 
pare for  the  termination  before  he  starts,  and  as  the  con- 
summation of  an  audit  must  include  a  report  on  his  work, 
this  fact  must  be  kept  in  view  during  the  progress  of  the 
work. 

If  feasible,  the  auditor  should  picture  himself  in  his 
client's  position  and  reason  out  what  he  would  want  if  the 
other  man  were  doing  the  work.  The  examination  may 
have  started  under  most  favorable  auspices;  it  may  have 

235 


236  AUDITING 

been  executed  in  an  unexcelled  manner,  but  if  it  is 
not  delivered  properly  the  first  two  factors  will  go  for 
naught. 

It  hardly  seems  necessary  to  state  that  reports  should 
be  typewritten  and  an  office  copy  preserved,  yet  auditors 
are  frequently  induced  to  submit  manuscripts  of  which 
no  copy  has  been  retained.  Subsequent  embarrassment 
has  followed  this  unwise  practice,  through  loss  of  the 
original,  unauthorized  alterations  therein,  etc.  It  is  better 
to  keep  a  client  waiting  than  to  run  such  a  risk.  Promises 
to  return  for  rewriting  are  not  kept,  as  a  rule,  and  the 
auditor  who  relies  on  these  and  similar  promises  ignores 
a  precaution  which  experience  has  demonstrated  to  be 
valuable. 

Something  More  Than  Figures  Are  Wanted  in  a  Report 

A  prominent  banker  recently  said  to  the  author  that 
most  of  the  reports  submitted  to  him  were  lacking  in 
information  which  the  auditor  was  peculiarly  able  to  fur- 
nish. He  said  that  auditors  who  are  retained  to  investi- 
gate earnings,  expenses,  assets,  and  liabilities,  frequently 
going  back  over  a  long  series  of  years,  have  an  unusually 
good  opportunity,  for  instance,  to  size  up  the  personnel 
of  an  organization,  particularly  the  office  staff,  but  also 
to  a  certain  extent  the  other  departments. 

A  banker  is  obliged  to  vouch  for  an  enterprise  as  a 
whole  when  he  offers  its  securities  to  his  customers.  He 
wants  the  assets  and  liabilities  and  net  profits  stated  in 
proper  form  for  publication,  and  requires  a  certificate 
attached  which  reads  well,  but  he  wants  a  supplemental 
report  for  his  own  use  expressing  the  auditor's  opinions 
on  just  as  many  points  as  the  latter  can  comment  on 
intelligently.  He  does  not  want  trial  balances  and  lists 
of  debtors  and  creditors  and  memoranda  of  errors  in  post- 


CERTIFICATES    AND    REPORTS  237 

ings  and  similar  bookkeeping  data.  He  will  read  only 
what  is  of  interest  to  him  and  these  things  are  not. 

The  same  principle  applies  to  the  client  whose  own 
accounts  are  being  reported  upon  by  an  auditor.  The 
auditor  secures  access  to  records  which  the  usual  execu- 
tive does  not  see,  and  has  a  chance  to  observe  the  staff 
under  conditions  which  do  not  exist  when  the  boss  is 
around.  This  does  not  contemplate  that  the  auditor  will 
report  trivial  matters  which  will  make  the  staff  hostile 
without  being  of  any  real  benefit  to  the  client. 

Elsewhere  in  this  book  it  has  been  pointed  out  that 
the  successful  auditor  must  secure  and  retain  the  hearty 
co-operation  of  the  of^ce  staff,  and  this  fact  is  here  reit- 
erated as  a  reminder  that  a  report  should  be  a  constructive 
document  and  helpful  to  the  client's  staff  as  well  as  to 
the  client.  Occasions  may  arise  where  the  auditor  cannot 
prevent  his  report  from  arousing  hostility  on  the  part  of 
the  staff.  If  this  must  be,  let  it  be  because  vital  defects 
are  criticized  and  not  trivial  ones. 

Terminology 

It  is  most  important  that  an  auditor  express  his  find- 
ings and  opinions  in  good  simple  English.  His  aim  must 
be  to  write  so  clearly  that  his  report  cannot  possibly  be 
misunderstood.  He  will  not  err  if  he  follows  the  simple 
language  of  the  Bible  or  of  Lincoln  rather  than  the  involved 
style  of  Henry  James. 

It  has  been  said  that  accounts  are  the  language  in 
which  business  transactions  are  written.  It  is  incumbent 
on  the  auditor  to  exemplify  the  fact  that  this  language 
is  a  simple  one,  and  readily  understood.  Classics  may  be 
read  in  dead  languages,  but  commonplace  business  history 
is  better  understood  if  written  in  a  live  tongue. 

Figures  in  themselves  are  of  no  value,  but  correctly 


238  AUDITING 

arranged  and  properly  interpreted,  the  accounts  of  a  busi- 
ness organization  furnish  a  basis  for  knowledge  which  is 
indispensable  in  the  successful  conduct  of  any  enterprise. 

The  truth  may  exist  in  a  report  poorly  written,  but 
if  it  is  not  evident  to  any  interested  party,  then  the  lan- 
guage used  is  not  well  chosen. 

The  following  memorandum  is  submitted  as  suggestive 
only,  but  it  is  more  than  hkely  that  it  would  be  read 
through  to  the  end  by  every  man  or  woman  who  might 
have  an  interest  in  the  enterprise  in  question. 

Statement  of  Financial  Condition  of  A  and  B 
At  the  Close  of  Business,  December  31,  1915 

The  total  assets  of  the  firm  on  this  date  amounted  to  $213,333,  con- 
sisting of  the  following  items :  Cash  in  bank,  $9,465.  This  is  somewhat 
less  than  is  usually  carried,  but  a  number  of  bills  were  paid  on  Decem- 
ber 31,  which  reduced  the  bank  balance  accordingly.  Bills  Receivable, 
$8,450.  These  are  notes  not  yet  due,  and  are  all  believed  to  be  good. 
They  can,  if  necessary,  be  discounted  at  the  bank  and  furnish  additional 
funds.  Accounts  Receivable,  $29,416.  These  were  gone  over  carefully 
on  December  31,  and  an  amount  equal  to  all  accounts  long  overdue  was 
charged  to  Profit  and  Loss  and  carried  to  Reserve  for  Bad  Debts  ac- 
count. They  are  also  carried  in  a  separate  ledger  and  are  being  care- 
fully looked  after,  and  a  fair  amount  will  no  doubt  be  realized  there- 
from. The  sales  for  the  month  of  December  were  nearly  $20,000,  and, 
as  practically  all  sales  are  at  thirty  days'  time,  it  is  evident  that  collec- 
tions are  in  fine  shape. 

Stock  was  taken  on  December  31  and  amounted  to  $39,460.  The 
market  was  somewhat  lower  on  that  date  than  when  most  of  the  goods 
were  purchased,  so,  in  order  to  be  conservative,  the  inventory  was  priced 
at  market.  All  obsolete  and  damaged  stock  was  inventoried,  but  was 
not  valued.  It  is  proposed  to  dispose  of  all  this  dead  stuflF  as  soon  as 
possible,  as  it  is  in  the  way,  and  is  the  source  of  constant  expense  and 
annoyance.  The  inventory  sheets  have  been  securely  bound  and  placed 
in  the  safe. 

The  insurance  on  stock  aggregates  $45,000,  which  is  about  10  per 
cent  in  excess  of  the  inventory.  The  rate,  however,  is  only  about  forty 
cents  since  the  installation  of  the  sprinkler  plant,  and,  as  the  amount 


CERTIFICATES    AND    REPORTS 


239 


fluctuates  from  day  to  day,  it  is  considered  advisable  to  cover  a  small 
margin  above  the  estimated  stock.  The  insurance  question  comes  up 
automatically  once  a  week  so  that  we  cannot  be  caught  unawares,  as 
was  the  case  recently  with  the  X  Y  Z  Company. 

In  November,  we  paid  the  insurance  for  an  entire  year  in  advance, 
so  that  on  December  31  the  proportion  prepaid  amounted  to  $762,  which 
is  carried  as  an  asset,  because  it  should  be  charged  against  the  opera- 
tions of  1916.  We  also  paid  the  discount  on  the  notes  at  bank  in  ad- 
vance to  the  extent  of  $412,  and  this  is  carried  as  an  asset  in  the  same 
way  as  the  insurance. 

On  a  conservative  basis,  the  furniture  and  fixtures  on  hand  on  De- 
cember 31  were  worth  over  $6,000,  but  as  liberal  depreciation  hns  been 
written  oflf  each  year,  this  item  now  stands  at  $3,418.  We  are  carrying 
insurance  for  $6,500,  however,  and  in  case  of  a  fire  there  would  be  no 
trouble  about  adjusting  the  loss  and  proving  our  claim,  as  a  carefully 
prepared  schedule  of  each  article,  with  date  of  purchase  and  cost  price, 
is  kept  in  the  safe. 

Our  land  and  buildings  are  now  carried  at  a  net  valuation  of  $84,710, 
made  up  as  follows:  Cost  of  land  in  1901,  $50,000;  cost  of  buildings, 
$49,862.  We  have  carried  to  our  reserve  account  annual  depreciation 
at  the  rate  of  4  per  cent  per  annum,  reducing  the  accounts  to  $34,710. 
This  rate  is  probably  too  high,  as  2^  per  cent  per  annum  is  stated  to 
be  the  proper  rate  of  depreciation  on  buildings  like  ours,  but,  as  the 
depreciation  is  charged  into  the  expenses  every  year,  it  keeps  us  on  the 
safe  side  when  figuring  our  costs,  and,  if  it  should  ever  be  considered 
advisable  to  tear  down  some  of  our  older  buildings,  the  rate  of  de- 
preciation charged  will  be  justified.  The  machinery  account  now  stands 
on  our  books  at  a  net  valuation  of  $37,240.  The  original  cost  of  the 
machinery  now  installed  in  the  plant  was  over  $60,000,  but  depreciation 
at  rates  varying  from  10  to  20  per  cent  per  annum  has  been  charged  on 
the  same  theory  as  with  buildings.  Much  of  our  machinery  is  of  a  type 
which  is  subject  to  improvements  and  new  inventions,  and,  as  has  been 
the  case  in  the  past,  some  so-called  modern  machines  may  become 
obsolete  over  night.  If  our  machinery  account  were  carried  on  our 
books  at  cost  or  nearly  so,  as  is  done  by  some  of  our  competitors,  we 
would  no  doubt  be  afraid  to  abandon  it  for  fear  of  the  resulting 
shrinkage  in  our  assets,  but  the  liberal  depreciation  charged  and  the 
consequent  margin  in  this  account  permit  us  to  keep  absolutely  up  to 
date  with  our  entire  equipment.  Unquestionably  a  fair  share  of  our 
continued  success  as  manufacturers  is  due  to  this  policy. 

Our  auditors  tell  us  that  they  have  never  examined  the  affairs  of  a 
single  bankrupt  concern  where  the  machinery  account  was  not  inflated 
by  reason  of  insufficient  depreciation  being  written  off,  and  they  point 
out  that  the  moral  is  obvious. 


240  AUDITING 

The  depreciation  on  buildings  and  machinery  is  not  deducted 
directly  from  the  respective  accounts,  but  is  carried  separately  as  a 
reserve.  The  reason  for  this  is  that  in  case  of  fire  we  can  submit  the 
cost  of  all  the  buildings  and  machinery  to  the  adjusters  and  show  them 
the  accounts  in  the  books.  We  have  a  subsidiary  building  and  machin- 
ery ledger,  which  shows  each  building  and  each  machine  separately  with 
cost  of  installation,  etc.  The  aggregates  of  the  detailed  items  in  this 
ledger  agree  exactly  with  the  totals  in  the  general  ledger. 

If  a  fire  occurred  it  would  be  a  matter  of  negotiation  as  to  the 
deductions  for  wear  and  tear,  and,  as  the  adjusters  would  be  obliged  to 
make  their  calculations  on  a  basis  of  the  life  of  the  buildings  and 
machines  or  their  replacement  cost,  we  ought  to  realize  a  much  larger 
amount  than  that  shown  in  the  balance  sheet.  This  conservative  valua- 
tion not  only  means  that  we  are  not  fooling  ourselves,  but  our  banks 
realize  that  we  are  not  fooling  them  and  compliment  us  on  our  method 
every  time  it  is  explained  to  them. 

The  President  of  the  National  Bank  told  us  a  short  time  ago  that 
he  believes  we  can  borrow  a  larger  amount  on  our  statement  as  it  is 
made  up  than  some  concerns  whose  plants  may  have  cost  far  more, 
but  whose  methods  are  not  as  conservative.  The  distrust  occasioned  by 
lack  of  conservatism  leads  a  banker  to  discount  all  the  assets  ruthlessly, 
while  with  us  they  feel  perfectly  safe  in  relying  on  our  figures  and  "go 
the  limit"  when  we  ask  for  credit. 

The  assets  referred  to  above  aggregate  at  their  reduced  valuation 
$213,333.  The  total  liabilities  on  December  31  amount  to  $74,493.  leav- 
ing net  capital  invested  in  the  business  $138,840,  of  which  there  stands 
to  the  credit  of  Mr.  A  $74,910,  and  to  the  credit  of  Mr.  B  $63,930. 

The  liabilities  in  detail  are  as  follows : 

Bills  payable,  $18,500,  consisting  of  three  notes  for  $5,000  each, 
and  one  for  $3,500.  The  former  were  discounted  at  the  National  Bank 
and  are  due  January  25,  February  25,  and  March  25.  The  $3,500  note 
was  discounted  at  the  Citizens  Bank  and  is  due  February  25.  As  our 
purchases  are  increasing,  due  to  the  approach  of  the  busy  season, 
these  notes  will  have  to  be  renewed  and  additional  funds  secured.  Our 
line  at  the  National  Bank  is  now  $40,000,  and  at  the  Citizens  Bank 
$25,000.  This  is  more  than  sufficient  to  carry  us  through  the  season 
and  will  enable  us  to  discount  all  our  bills.  The  unpaid  accounts  pay- 
able for  purchases  on  December  31  amounted  to  $24,218.  No  bills  are 
overdue,  and  all  invoices  carrying  cash  discounts  have  been  paid. 

The  collections  which  are  sure,  are  not  sufficient  to  meet  all  of  our 
bills  on  our  regular  pay  day  (the  20th),  so  $10,000  should  be  bor- 
rowed, say  on  the  18th.  The  accrued  wages  up  to  the  night  of  the 
31st  amounted  to  $1,340. 

The  taxes  accrued  to  the  same  date  amounted  to  $435.    This  repre- 


CERTIFICATES    AND    REPORTS  24 1 

sents  a  tax  rate  of  2  per  cent,  which  is  a  decided  advance  over  last 
year.  We  are  unable  to  discern  any  additional  benefits  arising  out  of 
the  increase,  and  it  might  be  in  order  to  suggest  to  the  municipal 
authorities  that  it  is  up  to  them  to  establish  efficiency  and  cost  records 
and  justify  the  enormous  sums  they  are  expending  annually  in  an 
apparently  aimless  manner. 

The  only  remaining  liability  is  the  mortgage  for  $30,000  on  the  real 
estate.  As  the  interest  rate  is  5  per  cent  and  as  it  is  not  due  for  three 
years,  no  action  with  respect  to  this  debt  is  suggested. 

The  foregoing  narrative  is  necessarily  colorless  and 
lacks  the  local  flavor  which  might  easily  be  woven  about 
the  balance  sheet  of  a  going  business,  so  that  as  read 
solely  by  those  connected  with  the  particular  undertaking, 
one  item  after  another  would  awaken  interest  and  stimu- 
late action  with  respect  to  those  figures  which  might 
appear  to  be  unfavorable. 

It  is  not  hard  to  imagine  a  state  of  afifairs  different 
from  that  described,  and  it  is  quite  within  reason  to 
prophesy  that  a  cleverly  written  description  of  balance 
sheets  in  the  manner  described  would  excite  decisive 
action  on  the  part  of  an  executive  with  respect  to  unfavor- 
able items  where  previous  efforts  along  routine  lines  had 
failed.  In  any  event,  it  is  well  worth  trying,  particularly 
in  connection  with  a  profit  and  loss  or  trading  statement 
where  comparisons  are  important  and  instructive.  An 
occasional  witticism  or  business  ''story"  would  not  be  out 
of  place,  assuming  always  that  a  proper  diagnosis  has  been 
made  of  the  executive  to  whom  the  report  is  addressed. 

Scope  of  Report 

Certificates  and  reports,  if  true,  must  be  founded  on 
the  work  which  has  been  done.  A  report  should  be  a  nar- 
rative of  facts.  It  may  include  a  short  history  of  the 
enterprise  under  audit,  particularly  where  it  is  intended 
for  the  perusal  of  those  whose  information  on  this  point 
is  limited. 


242 


AUDITING 


A  certificate  should  be  brief  and  to  the  point 
and  embody  conclusions  based  solely  on  the  auditor's 
investigations. 

A  report  is  for  the  edification  of  others,  and  it  is  the 
duty  of  the  auditor  to  make  it  interesting.  The  most 
successful  auditors  pay  much  attention  to  this  aspect  of 
their  work,  so  that  clients  are  glad  to  get  their  reports 
and  read  them. 

How  much  space  should  be  given  to  the  detailed  work 
done  by  the  auditor?  The  average  client  does  not  care 
how  the  auditor  arrived  at  his  results — all  he  wants  is 
information.  He  asks:  ''Are  the  accounts  correct,  or,  if 
not  correct,  wherein  are  they  inaccurate,  and  how  shall 
they  be  improved?" 

Some  auditors  who  have  not  verified  every  item  on 
the  books  think  that  they  escape  responsibility  by  detail- 
ing all  of  the  ground  covered.  If  work  is  omitted  which 
should  have  been  performed,  a  carefully  worded  report 
pointing  out  that  other  work  was  done  and  omitting  any 
mention  of  the  work  in  question  cannot  be  used  to  escape 
liability. 

Reports  must  be  founded  on  facts  discovered,  verified, 
or  compiled  by  the  auditor,  but  it  is  neither  desirable  nor 
necessary  to  comment  on  immaterial  matters  and  furnish 
superfluous  schedules. 

The  purpose  for  which  the  report  is  to  be  used  must 
in  every  case  be  carefully  considered  before  it  is  written. 
For  instance,  a  prospective  borrower  does  not  want  an 
auditor  to  submit  a  balance  sheet  which  is  accompanied 
by  comments  on  th'e  system  of  accounts,  nor  does  he  want 
long  schedules  of  clerical  errors.  On  the  other  hand,  it  is 
quite  in  order  to  submit  a  balance  sheet  accompanied  by 
qualifying  comments,  provided  the  changes  which  the 
auditor  thinks  should  be  made  in  the  balance  sheet  figures 


CERTIFICATES    AND    REPORTS  243 

are  not  permissible  in  the  books,  or  where  balance  sheet 
items  are  not  sufficiently  self-explanatory.  It  is  usually 
desirable  and  convenient  to  comment  on  balance  sheet 
items  in  the  same  order  in  which  they  appear  on  the 
balance  sheet. 

Where  balance  sheets  are  not  designed  for  publication 
the  most  satisfactory  report  consists  of  the  following: 
Certificate  of  audit. 

Comments  on  audit  and  on  balance  sheet. 
Balance  sheet,  supported  by  detailed  schedules  wher- 
ever they  are  necessary  or  deemed  to  be  of  prac- 
tical use. 
Profit  and  loss  statement,  divided  into  sections  or 

groups  and  supported  by  schedules  if  required. 
Special  schedules. 

Certificate  of  Audit 

The  certificate  should  be  as  short  and  concise  as  possible. 
Attempts  to  qualify  a  certificate  are  not  looked  on  with 
favor,  and  unless  an  auditor  has  been  greatly  restricted  in 
the  scope  of  the  audit,  it  is  his  duty  to  conform  as  nearly 
as  possible  to  the  "audited  and  found  correct"  style.  Of 
course,  where  qualifications  are  necessary  they  must  go  in 
without  fear  or  favor,  but  the  point  the  author  has  in  mind 
is  the  evident  fear  of  many  accountants  that  their  certifi- 
cates will  be  taken  seriously  and  acted  upon,  and  in  this 
fear  they  hedge  them  about  with  all  sorts  of  ambiguous 
qualifications.  Sometimes  they  sound  like  arguments,  i.e., 
the  certificate  will  read  in  effect  that  if  so  and  so  were 
done,  so  and  so  would  be  the  result.  Most  business  men 
will  listen  to  sound  arguments  before  the  report  is  written, 
and  the  changes  recommended  might  as  well  be  made 
in  the  balance  sheet  and  thus  permit  the  giving  of  an 
unqualified  certificate,  which  is  always  the  most  desirable. 


244  AUDITING 

A  form,  variations  of  which  are  used  by  leading  audit- 
ors, is  as  follows: 

The  Board  of  Directors, 
ABC  Company. 

We  have  audited  the  accounts  of  the  A  B  C  Company  for  the  year 
ended  December  31,  1915. 

We  verified  the  Cash,  the  Inventories  of  Raw  Materials  and  Sup- 
plies. Work  in  Progress,  and  Finished  Product,  and  the  other  current 
assets  as  of  December  31,  1915. 

The  Raw  Materials  and  Supplies  on  hand  and  in  process  of  manu- 
facture were  priced  at  cost,  except  that  where  market  values  at  Decem- 
ber 31,  1915,  were  less  than  cost,  the  inventories  were  reduced  to  market 
values.  Sufficient  reserves  have  been  made  for  probable  losses  on  notes 
and  accounts  receivable. 

We  examined  the  charges  to  capital  accounts  and  find  them  to 
represent  actual  additions  to  the  Company's  property.  Ample  allow- 
ances have  been  made  for  depreciation  of  plants.  All  known  liabilities 
have  been  included  in  the  accounts. 

We  Hereby  Certify  that  in  our  opinion  the  accompanying  balance 
sheet  and  profit  and  loss  statement  correctly  present  the  financial  con- 
dition of  the  Company  as  of  December  31,  1915,  and  its  operations  for 
the  year  ended  with  that  date. 

(Signed)  X  Y  Z, 

Certified  Public  Accountants. 

If  qualifications  are  necessary,  the  above  form  can  be 
used  as  a  basis  and  the  qualifications  mentioned  in  their 
proper  place. 

As  mentioned  heretofore,  some  certificates  may  require 
as  much  analysis  as  the  figures  themselves.  In  such  cases 
it  might  be  better  to  omit  the  certificate  in  the  annual 
report  of  a  corporation,  as  its  wide  publication,  chiefly  to 
those  who  need  simple  rather  than  complicated  reports, 
is  likely  to  do  more  harm  than  good.  The  following 
auditor's  certificate  (with  slight  changes)  was  circulated 
in  July,  1915,  to  many  thousands  of  stockholders  of  a 
large  corporation.  The  balance  sheet  contairied  many 
details,  yet  the  certificate  itself  was  about  as  complicated. 
The  certificate  was  substantially  as  follows: 


CERTIFICATES    AND    REPORTS  245 

We  have  audited  the  head  office  books  and  accounts  of  the  A,  B, 

and  C    companies  at ,  and  of  the  two  independently  operated 

companies  at and  ,  and  of  D  company  at , 

for  the  year  ending  May  31,  1915,  and,  accepting  the  financial  reports 
and  balance  sheets  submitted  to  us  for  all  other  subsidiary  companies, 
district  offices  and  branches,  whose  books  we  have  not  audited,  we  find 
that  the  above  Consolidated  Balance  Sheet  is  correctly  prepared  there- 
from. 

We  have  scrutinized  the  expenditures  added  to  property  accounts, 
and  are  satisfied  that  the  respective  items  are  of  the  nature  of  actual 
additions  or  permanent  improvements,  and  are  properly  chargeable  to 
capital   account.     All   expenditures  during   the  year   for   replacements 

and  maintenance  aggregating  $ have  been  charged  against 

operations,  but,  as  in  previous  years,  no  further  provision  has  been 
made  for  depreciation. 

The  inventories  of  raw  materials  and  manufactured  products  on 
hand  are  valued  at  cost  or  market  price,  whichever  was  the  lower.  The 
quantities  of  all  inventories  shown  by  the  system  of  cost  accounting 
have  been  confirmed  by  actual  count  or  measurement  as  at  May  31, 
1915,  made  by  responsible  officials. 

The  head  office  cash,  notes  and  other  securities  have  been  verified 
by  actual  inspection  or  certificates  from  depositaries  and  due  provision 
has  been  made  for  all  outstanding  liabilities.  Owing  to  the  exceptional 
business  conditions  prevailing  during  the  past  year,  an  unusual  propor- 
tion of  notes  and  accounts  receivable  have  not  been  paid  when  due 
(against  which  the  company  held  collateral  valued  at  approximately 
$ )  and  further  provision  against  losses  thereon  may  be  re- 
quired. 

Upon  the  basis  above  indicated,  we  certify  that  in  our  opinion  the 
above  Consolidated  Balance  Sheet  is  a  full  and  fair  statement,  and  is 
properly  drawn  up  so  as  to  show  the  true  financial  position  of  A  Com- 
pany and  its  subsidiary  companies  at  May  31,  1915. 

(Signed)  J  K  L, 

Certified  Public  Accountants. 

In  support  of  the  argument  for  a  short  form  of  certifi^ 
cate,  the  president  of  a  large  bank  wrote  to  the  author 
recently  and  said,  mter  alia,  '*We  frequently  observe  cer- 
tificates which  require  as  close  an  analysis  as  the  figures 
themselves.  Some  standardized  form  of  audit  ^yhich 
would  carry  with  it  all  that  the  word  implies,  would  be 
most  acceptable,  I  think,  to  bankers  generally." 


246 


AUDITING 


Where  a  shorter  form  is  wanted  for  a  certificate 
which  is  to  be  appended  to  the  condensed  balance  sheet 
used  by  note  brokers  and  others,  the  following  is 
acceptable: 

We  have  audited  the  accounts  of  the  D  E  F  Company  for  the  year 
ended  November  30,  1915,  and 

We  Certify  that  the  above  balance  sheet  and  statement  of  profit 
and  loss  agree  with  the  books  and  in  our  opinion  correctly  set  forth 
the  financial  condition  of  the  Company  as  of  November  30,  1915. 

(Signed)   R  S  T, 

Certified  Public  Accountants. 

The  question  sometimes  arises  as  to  how  to  submit  a 
balance  sheet  and  report  thereon  when  the  audit  is  made 
so  long  after  the  balance  sheet  that  adjustments  cannot 
be  made  as  of  that  date,  and  the  auditor  cannot  certify 
that  the  balance  sheet  ''agrees  with  the  books  and  is 
correct."  The  best  way  is  to  have  the  entries  journalized 
before  the  report  is  written,  and  no  matter  how  long  after 
the  date,  the  entries  should  read  ''as  of"  the  date  of  the 
balance  sheet,  and  when  posted  to  the  ledger  the  items 
should  be  connected  with  the  closing  date  by  a  star,  or 
asterisk.  Subsequent  trial  balances  and  any  subsequent 
references  will  then  find  the  accounts  in  order,  and  there 
can  be  no  difficulty  if  the  necessity  arises  for  their  being 
reconciled  with  the  balance  sheet. 

Wherever  the  auditor's  recommendations  as  to  adjust- 
ments of  asset  or  liability  items  are  not  or  cannot  be 
adopted  and  recorded  "as  of"  the  date  of  the  balance 
sheet,  the  most  satisfactory  form  of  report  thereon  is  to 
submit  the  balance  sheet  as  shown  by  the  books  and  pre- 
cede this  with  comments  which  will  be  bound  with  and 
permanently  attached  to  the  balance  sheet,  so  that  im- 
proper use  cannot  be  made  of  the  balance  sheet  by  remov- 
ing the  qualifying  comments. 


CERTIFICATES    AND    REPORTS 


247 


Clients  do  not  always  appreciate  the  position  of  an 
auditor  with  respect  to  the  use  of  balance  sheets.  Experi- 
ence has  shown  that  they  frequently  hope  for  a  more 
favorable  statement  than  they  receive,  and  as  the  audit 
may  be  for  the  purpose  of  securing  credit,  an  unfavorable 
statement  places  the  client  in  an  embarrassing  position. 
Auditors  must  always  be  on  their  guard,  therefore,  that 
balance  sheets  made  up  by  them  and  subject  to  qualifica- 
tion are  not  submitted  in  such  form  as  will  admit  of  their 
being  separated  from  the  qualifications. 

Based  on  long  experience  of  his  own  and  other  firms, 
the  author  believes  that  the  only  safe  method  of  reporting 
is  to  use  paper  bearing  one's  own  watermark.  This  is  not 
very  expensive  when  a  considerable  quantity  of  paper  is 
used. 

Where  an  auditor  is  able  to  construct  his  own  balance 
sheet  and  can  certify  thereon  that  it  is  correct,  it  does  not 
make  any  difference  whether  or  not  it  is  separated  from 
the  comments.  In  fact,  it  is  usually  preferable  to  submit 
such  a  balance  sheet  complete  in  itself. 

Form  of  Balance  Sheet 

Many  tiresome  pages  have  been  written  explaining, 
or  trying  to  explain,  why  it  is  that  universal  American 
custom  decrees  that  assets  shall  be  placed  on  the  left-hand 
side  of  the  balance  sheet  and  liabilities  on  the  right-hand 
side.  The  explanation  is  no  more  satisfactory  than  the 
reasons  advanced  by  English  authorities  to  support  their 
custom  of  placing  the  liabilities  on  the  left  and  the  assets 
on  the  right. 

The  author  ventures  the  following: 

The  English  practice  is  purely  the  outcome  of  custom. 
A  long  time  ago  some  one  started  that  way  and  every  one 
since  has  followed,  until  now  the  form  has  the  sanction 


248 


AUDITING 


of  law.  (See  forms  prescribed  under  the  English  Com- 
panies Act.) 

The  only  sound  reason  the  author  can  think  of  for 
the  custom  is  that  a  conservative  Englishman  looks  for 
his  liabilities  first  and  then  looks  to  see  if  he  has  enough 
assets  to  discharge  them. 

In  the  United  States,  accountancy  has  developed  more 
scientifically  than  in  England.  If  a  short  cut  is  logical 
we  take  it.  When  it  was  found  that  loose  leaves  were  far 
more  convenient  and  economical  to  handle  than  leaves 
bound  permanently  together,  we  adopted  them.  So  with 
balance  sheets.  It  was  observed  by  accountants  that  the 
average  American  looks  for  his  assets  first  and  subse- 
quently glances  at  his  liabilities  in  order  to  assure  himself 
that  his  excess  of  assets  is  as  much  as  he  believes  it  to  be. 

Furthermore,  it  is  common  sense  for  a  man  who  decides 
to  record  his  financial  condition  to  place  his  possessions 
first.  Frequently  a  man  has  few  or  no  liabilities,  so  that 
the  practice  of  stating  the  assets  first,  then  the  liabilities, 
if  any,  as  a  deduction  therefrom,  thus  arriving  at  the 
surplus,  is  the  logical  presentation  applicable  to  the 
great  majority  of  business  enterprises  in  the  United 
States. 

What  may  be  styled  the  account  form  of  balance  sheet 
is  one  with  the  assets  on  the  left  and  the  liabilities  and  net 
worth  on  the  right,  this  permitting  an  agreement  between 
the  totals  of  the  two  sides.  Sometimes  a  deficit  exists 
and  the  bookkeeper's  passion  for  making  things  balance 
is  so  strong  that  the  deficit  is  included  among  the  assets! 
The  almost  incredible  result  is  that  practically  all  pub- 
lished balance  sheets  consist  of  a  confusion  of  figures  on 
both  sides  which  exactly  agree  in  total.  The  reader 
thereof  who  is  not  trained  in  accounts  does  not  compre- 
hend the  details,  but  he  is  reassured  in  some  mysterious 


CERTIFICATES    AND    REPORTS  249 

way  when  he  finally  discovers  that  the  liabilities  at  least 
do  not  exceed  the  assets. 

The  author's  conception  of  an  ideal  balance  sheet  is 
one  which  will  set  forth: 

1.  The  assets,  properly  valued  and  grouped,  and 
arranged  in  the  order  of  their  availability. 

English  law  and  custom  may  be  against  this  form,  but 
nevertheless  it  is  the  most  readable  and  the  most  under- 
standable to  the  average  business  man.  Furthermore,  it 
has  the  sanction  of  the  bankers  and  credit  men  of  this 
country,  who  use  balance  sheets  oftener  than  any  other 
class.     (See  official  forms,  pages  253-267.) 

2.  The  liabilities  also  properly  grouped  and  arranged 
in  the  order  they  will,  or  should,  be  discharged. 

3.  If  possible  the  excess  of  the  assets  or  the  liabilities 
should  now  be  shown  in  order  that  there  may  be  clearly 
apparent  to  anyone  interested,  the  net  worth,  or  capital 
and  surplus,  of  the  enterprise. 

4.  A  statement  showing  to  whom  the  excess  belongs 
or  by  whom  it  is  due.  That  is,  if  a  corporation,  there 
should  be  shown  the  capital  stock  issued,  the  addition 
thereto  if  a  surplus  of  assets  exists,  or  the  deduction  there- 
from if  there  is  a  deficiency. 

Current  Assets: 

Cash 

Notes  and  Accounts  Receivable   . 
Inventories 

Deferred  Charges  to  Operation: 

Prepaid    Insurance,    etc 

Plant  Assets: 

Real  Estate 

Machinery,  Fixtures,  etc.      .        . 

Good-Will,  Patents,  etc ' 


$.... 

.        .        .  $.... 


250 


Notes  Payable  . 
Accounts  Payable 
Accrued  Wages   . 

Bonded  Debt 
Reserves 


Capital    Stock 
Surplus  (or  Deficit) 


AUDITING 
Liabilities 


$.... 


Excess  of  Assets 
(Or  Net  Worth) 


$. 


The  most  popular  form  among  large  industrial  cor- 
porations which  publish  their  balance  sheets  is  as  follows : 

Assets 
Plant  Assets: 

( Including  Real  Estate, 
Machinery,  Patents, 
Good-Will,  etc.)     .        .  $. 

Deferred  Charges  to  Opera- 
tions : 

Insurance,    Interest,    etc., 
Prepaid           .        .        .     . 
Current  Assets: 
Inventories         .        .        .     . 
Accounts  and  Notes  Re- 
ceivable   

Cash 


$.... 


Liabilities 

Capital  Stock 

Bonded  Debt 

Current  Liabilities: 
Notes  Payable  .        $. 
Accounts  Payable 
Accrued  Wages,  etc.  . 

.$.... 

Reserves 

Surplus  .... 



$.... 

But  the  above  arrangement  is  not  easy  reading  for 
one  unaccustomed  to  accounts,  and  it  presupposes  that 
the  reader  can  discriminate  between  actual  liabilities  and 
surplus.  So  long  as  it  is  unnecessary,  it  is  unfortunate 
that  the  surplus  must  be  included  under  a  caption  which 
is  misleading. 


CERTIFICATES    AND    REPORTS 
The  following  form  is  preferable: 


251 


Assets 

Liabilities  and  Capital 

Current  Assets : 

Current  Liabilities: 

Cash    .        .        . 

$.... 

Notes  and  Accounts  Pay- 

Notes and  Account* 

> 

able          .        .        .        .$.... 

Receivable 

....  $.... 

Bonded  Debt        

Reserves        

Inventories 



Deferred  Charges  to 

Opera- 

tion 

.        .     ...  - 

Total  Liabilities        .        .  $ 

Excess  of  Assets,  made  up 

Plant  Assets: 

as  follows: 

Real  Estate,  etc. 



Capital  Stock     .        $.... 
Surplus  (or  Deficit)     

Good- Will,  etc.     . 

Total  Liabilities 

Total  Assets 

.        .$.... 

and  Capital       .        .  $ 

It  is  asserted  that  there  is  a  demand  for  the  form  of 
balance  sheet  given  on  page  250  from  those  whose  chief 
desire  is  to  see  the  relation  of  the  fixed  assets  to  the  cap- 
ital stock.  But  this  information  could  be  more  readily 
secured  from  the  above  form,  because  where  fixed  items 
appear  first  it  is  usual  to  place  the  capital  stock  first 
among  the  liabilities  and  the  surplus  last.  As  the  sur- 
plus may  be  as  large  as  or  larger  than  the  capital,  it  is 
very  necessary  to  have  these  figures  nearer  together,  as 
provided  in  the  second  form. 

It  is,  of  course,  impossible  to  mention  by  name  the 
assets  and  liabilities  which  are  found  in  different  enter- 
prises, therefore  these  outline  forms  must  be  suggestive 
only.  It  is  hoped  that  other  chapters  of  this  book  in 
which  is  pointed  out  the  importance  of  the  auditor's  plac- 
ing himself  as  far  as  possible  in  the  position  of  the  one 
who  is  to  use  the  accounts  will  be  more  helpful  in  framing 
a  balance  sheet  than  a  set  form  which  might  apply  in  a 


252 


AUDITING 


few  cases,  but  which  would  be  restrictive  and  therefore 
of  little  value  in  others. 

One  general  principle  which  should  be  observed  in  all 
balance  sheets  is  that  the  matter  of  the  arrangement  of 
the  groups  is  not  of  so  much  importance  as  the  relation 
of  one  to  the  other.  That  is,  it  does  not  greatly  matter 
whether  the  fixed  assets  are  first  or  last,  but  it  is  impor- 
tant that  the  balance  sheet  shall  indicate,  if  at  all  possible, 
the  relation  of  the  fixed  assets  to  the  other  assets  and  to 
the  liabilities.  For  instance,  a  concern  owning  a  million 
dollars  of  fixed  assets  should  have  a  capital  and  surplus, 
or  funded  debt,  of  at  least  as  much,  otherwise  the  current 
liabilities  would  be  excessive. 

Statement  Required  by  Banks 

For  some  years  bankers  have  required  borrowers  to 
furnish  statements  of  their  assets  and  liabilities.  At  first 
a  uniform  statement  was  not  insisted  on,  but  it  was  found 
that  some  borrowers  were  disinclined  to  submit  full 
reports  and  others  did  not  know  what  details  the  banker 
wanted.  Individual  banks  thereupon  compiled  their  own 
forms  and  furnished  blanks  to  their  customers.  These 
blanks  were  by  no  means  uniform,  and  as  many  borrowers 
used  more  than  one  bank,  the  diversity  became  a  nuisance 
to  both  banks  and  borrowers.  The  former,  in  exchanging 
credit  information  with  other  banks,  found  comparisons 
difficult,  and  the  latter  were  put  to  unnecessary  trouble 
in  arranging  and  rearranging  their  statements. 

Finally  an  attempt  was  made  through  the  various 
bankers'  associations  to  formulate  a  uniform  or  standard 
blank  which  would  embody  the  information  most  useful 
to  banks.  This  plan  was  entirely  successful  and  resulted 
in  the  present  standard  form  of  borrowers'  statement. 
The  form  which  is  reproduced  herewith  is  that  officially 
adopted  by  the  New  York  State  Bankers'  Association: 


CERTIFICATES    AND    REPORTS 


253 


STANDARD  FORM  OF  BORROWERS'  STATEMENT 

To  THE Bank  : 

For  the  purpose  of  procuring  credit  from  time  to  time  with  you  for 
our  negotiable  paper  or  otherwise,  we  furnish  the  following  as  a  true 

and  accurate  statement  of  our  financial  condition  on 191...,  which 

we  may  hereafter  be  considered  as  representing  to  be  a  true  statement 
of  our  financial  condition  unless  notice  of  change  is  given  you. 

ASSETS    ■ 


Cash  on  hand  and  in  bank 

Notes  Receivable  of  customers  (not  transferred)     . 

Accounts  Receivable  of  customers  (not  transferred) 

Notes  and  Accounts  Receivable  of  officers  (not 
transferred) 

Merchandise  finished  (how  valued )     . 

"  unfinished  (how  valued )     . 

"  raw   material     (how  valued )     . 

Land  owned  by  corporation,  used  for  this  business    . 

Buildings  owned  by  corporation,  used  for  this  busi- 
ness       

Machinery  owned  by  corporation,  used  for  this  busi- 
ness  


TOTAL 


LIABILITIES 


Notes  Payable  given  for  merchandise 
Notes  Payable  negotiated  to  own  banks 
Notes  Payable  otherwise  disposed  of 
Accounts   Payable        .... 
Deposits  of  Money  with  Us 


Bonded  Debt  (when  due) 
Mortgage  Debt 
Chattel  Mortgages 


Total  Liabilities 

Capital    .    ' 

Surplus  including  Undivided  Profits 

TOTAL 


254 


AUDITING 


Standard  Form  of  Borrowers'  Statement — Continued 
CONTINGENT  LIABILITY:  Notes  Receivable  of  customers  Dis- 
counted  or    Sold   and   not   included   in   assets   enumerated   above 

$ 

Other  contingent  liability $ 

We  Have  Not  Pledged  or  Assigned  any  of  the  above  Accounts  Receiv- 
able ;  our  Assigned  Accounts  Receivable  amount  to  $ 

Other  assets  used  as  collateral 

INSURANCE:  on  merchandise  $. ..' buildings  $ 

machinery  $ Total  Insurance 

BUSINESS    and   RESULTS:    Annual    Sales    for   the   year    ended 

191..  or  from 191.  .to 191.. 

Gross  Profits  on  Sales  for  the  same  period  $ 

Expense  of  Conducting  Business       "     "      "         *' 
Net  Profit  "     "      "         " 

Other  Income  including  investments     "     "      "         " 
Combined  Profit  "     "      "         " 

DIVIDENDS  PAID  for  the  period 191.. to 191..$ 

BAD  DEBTS  for  the  period 191 .  .to 191 .  .$ 

CAPITAL:  Authorized  $ Issued   $ 

Par  Value  $ per  share 

BANK  ACCOUNTS :  where  kept 

MORTGAGES  and  BONDS  on  what  assets  a  lien 

Average  TERMS  on  which  we  SELL 

Average  TERMS  on  which  we  BUY 

TIME  OF  YEAR  when  NOTES  and  ACCOUNTS  RECEIVABLE  of 

CUSTOMERS,  Uncollected,  are  generally  maximum 

minimum 

TIME  OF  YEAR  when  STOCKS  of  MERCHANDISE  on  hand  are 

generally  maximum minimum 

TIME  OF  YEAR  when  LIABILITIES  are  maximum 

minimum 

STATEMENT :  is  it  based  on  actual  Inventory  ? 

if  so,  Date 

VERIFICATION :  have  the  books  been  audited  by  a  Certified  Public 

Accountant? if  so,  Name  and  Date  of  Audit 

(Sign  corporation  name) 


Date  Signed 191 . . 


CERTIFICATES    AND    REPORTS  255 

This  form  is  more  explicit  and  desirable  than  that  offi- 
cially recommended  by  the  American  Bankers'  Associa- 
tion. In  the  New  York  State  form  the  matter  of  hypothe- 
cations is  brought  prominently  to  the  attention  of  the 
prospective  borrower.  In  the  light  of  many  unfortunate 
experiences  where  liens  on  accounts  and  stock-in-trade 
have  been  concealed,  the  importance  of  this  possibility  is 
unquestioned. 

Furthermore,  in  the  American  Bankers'  form  there  is 
danger  in  the  arrangement  of  the  assets  and  liabilities  in 
that  reserves  are  not  deducted  from  the  former  nor 
included  among  the  latter,  thus  permitting  the  inference 
that  by  deducting  the  liabilities  as  shown  from  the  assets 
as  shoivn  the  net  worth  of  the  corporation  may  be 
ascertained. 

It  is  true  that  reserves  are  not  liabilities,  but  where 
they  are  created  in  order  to  provide  for  depreciation,  bad 
debts,  etc.,  the  aggregate  thereof  is  a  direct  deduction 
from  the  assets,  and  borrowers  should  not  be  encouraged 
in  the  belief  that  a  banker  considers  that  the  "total" 
assets  and  the  "total"  liabilities  may  be  stated  before  con- 
sideration is  given  to  items  which  are  in  fact  directly  re- 
lated thereto. 

The  following  is  the  "short  form"  recommended  by 
the  American  Bankers'  Association; 


256 


AUDITING 


ASSETS                                                   H 

LIABILITIES 

Caih 

NOTBB  PlYABLB 

TOTAL 
TOTAL 

~~* 

Bills  Rbccivable  fwETl 
Accounts  Rkc«iv«blb  (n«t) 

MlBCHANDMB 

l.AMD 

BuiLDIMOa 

MaCHINBBY— FiXTUBBS 

.... 

:*::: 

:::: 

Dsposin 
UoNDKD  Debt 
mobtoaqbs 

Capital 

Surplus— PmoriTB 
Keskbvbs 

.'.'.'.'.'. 

!!'.! 

:::::: 

.... 



TOTAL 

1      .     1 

1           1           \ 

CONTINGENT  LIABILITIES.    On  bills  receivEble  discoonted Other 

CASH.    On  hand  and  in  bank,  | ....Kamei  of  banks i 

BILLS  RECEIVABLE.    Any  OTerdna  or  doobttnl  t Any  from  offlcers,  dirsctOrs,  8ab<«oini>aniei,  or  itisllar  aoarces 

ACCOUNTS  RECEIVABf.K.  State  Mnonnt  donblful,  not  from  nstomsrsor  in  any  way  not  reaUi«ble  within  lmmediat«  fntars. . . . 

MERCHANDISE.    Finished Unfinished Raw Valued  at  cost  or  market  1 ball  salable  t ^. 

LAND.    DescribObHsfly ~ Assessed  Talne Market  Talus 

BUTLPmOS.    CortI f.AC* DeprwHatlon 

MACHINERY  AND  FIXTURES.    Cort  • Depreciation CondlUott 

OTHER  ASSETS. 

Areany  of  assets  nnsTallable  for  paying  debts! LoMes 


INSURANCE.    State  what  kind  and 


NOTES  PAYABLE.    To  own  banks.... Through  brokers... Othsrwist 

ACCOUNTS  PAYABLE.    Terms  of  purchase  ? Do  you  discount  and  anticipate  I 

DEPOSITS.    Time  or  demand ! ;... From  whom* Interest , 

BONDED  DEBT  AND  MORTOAOE-S.    Due! Rate On  what  assete  a  Uen t 

ACCRUED  LIABILITIES.     Itemlie ^ «■ 

CAPITAL.    Preferred  Authorised  | Issued  $ Wrldendi Common  Aothorlied  $ Issued i Dlridends  | . 

RF.SERVES.    Itemizs , • 


NET  SALES. 


Cost  of  sales • 

1       Gross  profit ,'.... 

iBtifNst.  taxes,  depreciation,  sic. 

DiTidends  paid 

Surplus  for  year • 

Hare  the  books  been  audited  by  a  CcrUfled  Public  Aoeountent  t..  ..If  so,  glre  1 


of  firm  and  date  of  audit. 


CORPORATE  NAME. 


Date  signed 

Office  addreu 

^mitioo  of  plante  and  branch  ofllcea. . 


By. 
.Mature  «t  Bwlness.. 


(SUte  officer's  tlUe) 


CERTIFICATES    AND    REPORTS 


257 


To  a  professional  auditor  the  question,  ''Have  the 
books  been  audited  by  a  Certified  PubHc  Accountant?"  is 
of  particular  interest.  This  question  was  suggested  by 
James  G.  Cannon,  of  New  York  City,  who  has  for  many 
years  advised  bankers  to  use  professional  auditors  more 
generally. 

Unfortunately  for  both  bankers  and  auditors,  the  for- 
mer have  not  had  the  nerve  to  take  this  advice  except  to 
a  limited  extent.  There  have,  however,  been  some 
''horrible  examples"  where  the  calling  in  of  auditors  pre- 
vious to  making  loans  would  have  saved  the  banks  mil- 
lions of  dollars. 

It  will  be  noticed  that  the  bankers  wish  to  read  the 
statements  just  reproduced,  along  the  lines  advocated  on 
page  249  hereof;  that  is,  they  want  to  know  about  the 
assets«in  the  order  of  their  availability,  and  want  to  ascer- 
tain the  liabilities  in  the  order  they  must  be  discharged. 

A  more  recent  form,  prepared  by  the  credit  manager 
of  one  of  the  largest  national  banks  in  the  United  States, 
is  shown  in  detail  on  pages  258  to  263  inclusive.  This 
form  follows  the  rules  laid  down  by  the  Federal  Reserve 
Board  and  is  the  best  one  to  which  the  author's  attention 
has  been  drawn.  It  was  prepared  by  Abraham  E.  Van 
Doren,  of  the  Irving  National  Bank  of  New  York. 

A  desirable  innovation  in  this  form  is  found  in  the  pro- 
vision for  a  notary's  certificate.  Together  with  other 
features,  which  are  designed  to  put  the  borrower  squarely 
on  record  as  to  his  actual  assets  and  liabilities,  this  form  is 
expected  to  furnish  legal  evidence  suf^cient  to  convict  the 
borrower  of  fraud  if  it  is  shown  subsequently  that  any 
material  discrepancy  existed  between  the  statement  and 
his  books. 


258 


AUDITING 


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CERTIFICATES    AND    REPORTS 


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AUDITING 


Schedule  A — Depositary  Banks  and  Other  Sources 

OF  Credit 


Depositary  Banks 

Cash 
Balance 
at  Date  of 
Statement 

Line 

of  Credit 

Received 

from  Each 

Amount 

Owing 

at  Date  of 

Statement 

Security 
Indorse- 
ments or 
Guarantees 

Other  Sources  of  Credit 
Branch    Borrowing    Included 

Total  as  per 

Balance   Sheet  . 

Schedule  B — Notes  and  Accounts  Receivable 

Notes       Accounts 
Description  Receivable  Receivable 

Due  from  Trade  Debtors  only — upon  usual  terms    . 
Due  from  Trade  Debtors — over  six  months  old 
Due  from  Officers,     Directors,     Stockholders,     or 

Employees 

Due  from  Own  Selling  Houses  or  Branches  . 
Due  from  Subsidiary  Corporations  .... 
Due  from  Allied  or  Controlled  Interests 

Due  from  Capital  Stock  Sold 

Amount    of      Consignment     Accounts  —  included 

herein  $ 

Amount   Discounted,   or   Pledged,   or   Assigned — 

included  herein  $ 

Notes  Receivable — Past  Due 

Notes  Receivable — Renewals  of  Notes  Previously 

Taken        

Other  Accounts  or  Notes  Receivable 

Total  .        .        . 
Less  Reserve  created  to  cover  possible  discount 
and  losses 

Total  as  per  Balance  Sheet 


Schedule  C— Inventory 

(The  within  Statement  is  based  upon  an  (estimated)   Actual  Physical 
Inventory  taken ,  19. .,  By ) 

Description  Insurance   Amount 

Finished  Merchandise        .     (How  priced?* ) 

Merchandise  in  Process     .     (     "         "  ) 

•Inventory  should  be  taken  at  cost  or  market  price,  whichever  is  lowei. 


CERTIFICATES    AND    REPORTS 

Raw  Material      .        .        .     (How  priced? ) 

Supplies,  etc.       .        .        .     (     "  "        % . ) 

Total 

Less  Amount  of  Merchandise  of  Obsolete  Pattern  or  other- 
wise not  readily  salable 

Total  as  per  Balance  Sheet       .... 

Other  items  included  in  inventory 

What  amount  is  held  under  trust  receipt  by  you?    . 

What  amount  do  you  hold  on  consignment  (included  in  in- 
ventory) ? 

What  amount  has  been  pledged  as  collateral  for  loans  or 
advances?     

Total 


261 


Schedule  D — Real  Estate 

{Please  give  particulars  of  each  parcel.) 


Description     Location     Title  in  Name  of     Value     Mortgages     Equity 


Is  any  Good- Will  included  in   Plant  Account? 

What  provision  is  made  to  cover  depreciation  on  Buildings,  Machinery, 

and  Fixtures,  Real  Estate,  and  Plant  Account  ? 

Listed  at  cost,  appraisement,  or  market  value  ? 


Schedule  E — Investments — Any  pledged? 


Description  of 
Security 

Number  of 
Shares  Held 

Number  of 
Bonds  Held 

Par  Value 

Market  Value 

Income  or  Div. 
Received 
Last  ^  ;ar 

Schedule  F — Deposits  of  Money 

Name  of  Depositor 

Amount 

Security 

Maturity 

Rate  of 
Interest 

262 


AUDITING 


Schedule  G — Bonded  Debt 


Amount 
Authorized 


Amount 

Issued  and 

Outstanding 


Amount 
Issued  and 

Held  in 
Treasury 


Amount 
Pledged  as 
Collateral 
to  Loans 


Maturity 
Date 


Rate  of 
Interest 


Trustee  of 
Mortgage 


On  what  assets  are  the  above  described  bonds  a  lien?. 
Provision  for  retirement 


Form 
Fire 

Credit  .//...//..'.'.. .',...'.'. 

Liability  or  Casualty 

Life  (in  favor  of  Company). 
Other  Kinds 


Insurance 

Assets  Covered 
Merchandise  ... 
Buildings  and  Eauipment     . 
Accounts  and  Bills  Receiv- 
able     .        .        .        i        , 
Employees 
Indorsers  or  Executives 


Amount 


Verification  : 

If  your  books  have  been  audited  by  a  certified  public  accountant, 
state  his  name  and  date  of  audit. 

Name Date 


Maximum  and  Minimum  Requirements: 

When  did  your  liabilities  reach  their  maximum  last  year  and  what 
was  the  amount  ? Month 

When  did  your  liabilities  reach  their  minimum  last  year  and  what 
was  the  amount  ? Month 

Character  of  Business  (Federal  Reserve  Requirement)  : 
Describe  briefly  the  character  of  business  you  conduct. 


Contingent  Liability 
(Federal  Reserve  Requirement) 


Form 


Amount 


Upon  customers'  notes  dis- 
counted, sold  or  other- 
wise transferred 

Upon  drafts  negotiated 

For  accommodation  in- 
dorsements 

For  guarantees  given 

Upon  leases 


Form 


Amount 


Upon  bonds  or  other  obli- 
gations of  subsidiary 
companies 

Under  contracts  or  pur- 
chase arrangements 

Under  agreements 

Under  pending  lawsuits    . 


CERTIFICATES    AND    REPORTS  263 

This  company  is  not  a  guarantor  or  indorser  of  any  liabilities  or 
obligations  of  any  individual,  firm,  or  corporation,  and  it  is  not  liable 
under  any  contracts,  bonds,  or  profit-sharing  arrangements,  or  any 
other  agreements,  and  there  are  no  lawsuits  pending  except  as  set 
forth  above. 

Sign  Company's  name  here 

By 

N.  B. — It  is  most  essential  that  each  question  be  fully  answered. 

Federal  Reserve  Board  Requirements 

The  Federal  Reserve  Board,  whose  regulations  should 
in  time  become  the  controlling  authority  with  respect 
to  financial  statements,  has  issued  model  forms,  the  one 
for  corporations  being  reproduced  on  page  264. 

The  board  suggests  that  the  credit  files  of  member 
banks  should  include  information  concerning  the  follow- 
ing matters: 

1.  The  nature  of  the  business  or  occupation  of  the 

borrower. 

2.  If  an  individual,  information  as  to  his  indebtedness 

and  his  financial  responsibility. 

3.  If  a  firm  or  corporation,  a  balance  sheet  showing 

quick  assets,  slow  assets,  permanent  or  fixed 
assets,  current  liabilities  and  accounts,  short- 
term  loans,  long-term  loans,  capital  and  surplus. 

4.  All   contingent   liabiUties,   such  as  indorsements, 

guarantees,  etc. 
6.  Particulars    respecting   any   mortgage    debt    and 

whether  there  is  any  lien  on  current  assets. 
6.  Such  other  information  as  may  be  necessary  to 
determine  whether  the  borrower  is  entitled  to 
credit  in  the  form  of  short-term  loans. 
The    credit    files,    it    is    expected,    will    be    generally 
adopted,  although  it  is  to  be  noted  that  the  regulations 
of  the  board  do  not  absolutely  require  their  adoption. 

It  will  be  noted  that  care  has  been  taken  to  separate 
"slow'*     from    "quick"    assets,    and    "short-term"     from 


264 


AUDITING 


*'long-term"  loans.  As  this  separation  merely  follows 
long  time  practice  of  professional  auditors,  no  further 
comment  is  required  thereon. 

The  form  of  statement  reproduced  below  embodies  these 
recommendations. 


To Bank  OF 

We  make  the  following  uacement  of  all  the  atiaets  and  liabilities  of  this  companv  at  the  close  of  t 
give  other  material  information  for  the  purpose  of  obtaining  advances  on  notes  and  billt  bearing  our  signature  < 


ASSETS 


Cash  00  Hand  and  ia  Banks. . 

Accounts  Receivabie 

Notes  Receivable 

Merchandise , 

Other  Quick  Assets  (ItemizeX-  ■ 


LIABILITIES 


Accounts  Payable 

Notes  Payable  to  Banks 

Notes  Payable  to  Othe* 

Depoaiu 

Other  Current  LiabiUtiM  (Itemixe)  . 


Land  and  Buildings 

Machinery  and  Fixtures. 
Other  Asseu  Otenuse).. 


Bonded  Debt 

Other  LiabiUtiea  atemize). 


TOTAL 


Cmmit  anil  Deferred  LlaMUtlaa 

Capital  Stock  Pieferred 

Capital  Stock  Common 

Surplus  and  Undivided  Profits 


TOTAL 


MerchandUe.    On  what  basis  valued,  cost  or  market?... 

Finished! Unfinished* Raw*. 

If  any  goods  are  on  1 


Contfnaent  Liability.    Asindorserf 

As  guarantor  $ ..    Xo 

or  aaogned  except  as  follows:. , 


aceounu  have  been  sold 


AecoHnta  and  Notea  Payable.     If  any  are  past  due  sate  «nioiuit 


Sales  and  Prcata  Last  Fiscal  Yaar.    Netnlesf 

Net  pro&U  % Dividends  paid  ( 

Accoania  and  Notea  Receivable.     If  any  are  past  due  or 
aUte  amount  and  circumstances 


During    last    fisod    year    current    liabilities 

» ....)on „ 

and  at  a  minimum  (I )  on... 

Mortgagee  nnd  Bonds.  Sute  due  dates  of 


If  any  amounta  are  doe  60m  tfrectors^  oSoen,  employees,  subsidiaries, 


State  due  date  of  bonds  and  oa  what  assets  a  Ueo . 


Are  mortgages  or  bonds  a  lien  on  any  carrent  assets?. 

I  f  any  other  liens  00  assets,  state  amount  and  drconistaaces .... , 


■  oofttaiocO  ^rboth  suM 


Signed  this. 


CERTIFICATES    AND    REPORTS 


265 


U  whM  (Mte  incorpontad? 
U 


An  book*  audited  by  >  certified  public aocoantant?, ■.,..,: Give  d>t«  rf  lut  audit. 


In  order  that  there  may  here  be  a  full  presentation  of 
the  forms  in  general  use  throughout  the  United  States, 
we  will  next  consider  the  ones  issued  by  the  mercantile 
agencies.  These  forms  are  supplied  to  practically  every 
business  concern  in  existence,  and  are  therefore  more 
familiar  to  the  average  business  man  than  any  other.  The 
arrangement  is  not  ideal  by  any  means  and  the  informa- 
tion which  may  be  gathered  from  it  falls  far  short  of  that 
supplied  by  the  bankers'  and  credit  men's  associations.  It 
is  possible  that  the  agencies  do  not  feel  at  liberty  to 
request  as  full  a  statement  as  the  others,  but  it  is  obvious 
that  their  forms  might  be  improved  without  seriously 
affecting  their  chances  of  securing  information.  The  cor- 
poration forms  in  use  by  the  two  large  agencies  are  as 
follows: 


266  AUDITING 

(First  Form)     . 
STATEMENT  OF  FINANCIAL  CONDITION 


Name 

Engaged  in  the  business  of 

Located  at 

From  Inventory  of 19. .  Dated 19.. 

Under  what  state  laws  incorporated  ? When  ? 

Authorized  capital Subscribed  capital  ? 

Preferred  stock  ? Common  stock  ? 

Bonded  debt Bearing  interest  at per  cent. 

ASSETS 

Stock  on  hand,  raw  and  finished      ,        .        .        .        $ 

Amount  of  book  accounts  considered  good  .        .  

Amount  of  notes  considered  good  .        .        .  

Cash  in  bank 

Cash  on  hand 

Machinery  and  fixtures 

Any  other  assets,  exclusive  of  patent  rights 


REAL  ESTATE,  consisting  of. 
Total  Assets 


LIABILITIES 

For  merchandise        .        .        .  $ 

For  machinery  and  fixtures      

For  borrowed  money         

For  mortgage  on  real  estate    

For  all  other  liabilities     

Total  Liabilities , 


Total  Assets  over  Liabilities     . 

Is  the  surplus  at  the  risk  of  the  business? r. . 

Do  you  keep  books  of  account  of  the  business?. 

If  so,  what  books  ? 

Do  you  borrow  on  accounts  receivable? 


Date  last  dividend  declared How  much.  , . . 

INSURANCE  ON  STOCK,  $ ON  BUILDINGS, 

Annual  rent,  $ Annual  business,  $ 


CERTIFICATES    AND    REPORTS 


267 


(Second  Form) 
STATEMENT   OF    FINANCIAL   CONDITION 


ASSETS 19 

Cash  in  banks 

Cash  on  hand 

Notes  receivable,  actual  value 

Accounts  receivable,  actual  value 

Merchandise   (finished  and  unfinished) 

Raw  material 

Machinery  and  fixtures 

Real  estate 

Other   investments    (not   including   patents,   trade-marks 

patterns,  etc.) 

Total  Assets 

How   much,   if  any,   of  above   accounts   receivable   have 

been  assigned  or  pledged  for  loans  .        .     $ 


LIABILITIES 19 

Capital  stock  paid  in 
Surplus  and  undivided  profits 
Bills  payable      .... 
Accounts  payable 
Bonded  debt     .        .  . 

Mortgage  on  real  estate  (not  included  as  bonded  debt) 
.Chattel  mortgage  on  all  kinds  of  property   . 
Borrowed  money  from  banks  (not  included  above)  . 
"  "  "       individuals  (not  included  above) 

All  other  liabilities 

Total  Liabilities 

How  much,  if  any,  of  the  above  indebtedness 
is  past  due $ 


CAPITAL 

Authorized 


Common  stock  . 

Preferred  stock. 

How  PAID  in: 
In  cash  . 

Patents,  trade-marks. 
In  other  property 


Subscribed        Paid  in 

$ $ 

$ $ 


patterns,  etc. 


$ 

$ 

$ $. 


Give  particulars  and  the  value  of  each  kind  of  property. 


Amount  of  annual  business $ 

Amount  of  annual  expense $...., 

Annual  dividend , 

Surplus  (not  including  undivided  profits)  .  .  .  .$...., 
Indebtedness  of  company  to  stockholders  included  in  liabilities... 
Amount  of  insurance  on  merchandise  .        .        .        .$.... 

Amount  of  insurance  on  buildings  and  plant     .        .        .    $ 

Ever  had  a  fire ;  if  so,  give  particulars 

Other  interests  of  principal  directors 


CHAPTER    XIII 

CERTIFICATES    AND    REPORTS    (Continued) 

Statements  Requested  by  Credit  Managers 

The  scientific  granting  of  credit  requires  a  high  degree 
of  ability,  and  this  is  possessed  by  the  modern  credit  man- 
ager, or  he  would  not  occupy  the  important  position  which 
he  fills  today.  Nevertheless,  he  does  not  depend  solely  on 
the  data  he  can  secure  from  the  mercantile  agencies  and 
similar  sources,  and  many  concerns  have  adopted  their 
own  system  of  credit  reports  from  customers  and  pros- 
pective customers. 

The  form  recommended  and  indorsed  by  the  National 
Association  of  Credit  Men  does  not  differ  materially  from 
that  used  by  bankers,  but  it  is  believed  that  the  exact 
form  will  be  of  interest  to  those  who  are  anxious  to  ascer- 
tain the  point  of  view  of  men  to  tvhom  reports  are  fre- 
quently addressed.  As  stated  elsewhere,  the  auditor  who 
prepares  his  reports  in  a  form  easily  read  and  easily  under- 
stood by  those  for  whom  they  are  intended  will  be  the 
most  successful. 

Preceding  the  form  is  the  following  pertinent  observa- 
tion: 

Large  assets  are  not  always  necessary  to  the  creation  of  credit. 
What  is  most  desirable  is,  that  credit  be  in  relative  proportion  to  the 
actual  assets.  The  giver  of  credit  is  a  contributor  of  capital,  and  be- 
comes, in  a  certain  sense,  a  partner  of  the  debtor,  and,  as  such,  has  a 
perfect  right  to  complete  information  of  the  debtor's  condition  at  all 
times. 

268 


CERTIFICATES    AND    REPORTS  269 

Those  accountants  who  call  a  deficit  an  asset  and 
classify  capital  stock  and  surplus  as  liabilities  will  be 
shocked  to  see  the  informality  of  the  form  on  pages  270-272. 
It  brings  out  in  strong  relief,  almost  brutally,  the  "total 
active  business  assets,"  and  the  "total  business  liabiUties"; 
and  it  is  evident  from  the  spaces  provided  that  the  differ- 
ence between  the  two  must  be  the  "net  worth." 

It  is  a  corporation  blank,  but  the  intelligent  mind  that 
devised  the  form  was  not  hampered  by  the  fetish  of  trying 
to  make  the  two  sides  balance,  but  went  straight  to  the 
point  and  asked  for  the  information  which  a  credit  man- 
ager, or  a  business  man,  or  a  banker  wants.  Too  much 
emphasis  cannot  be  placed  upon  this.  Clients  assume  that 
their  own  bookkeepers  can  prepare  trial  balances;  that  is, 
if  they  think  about  the  matter  of  balancing  at  all.  Pro- 
fessional auditors  must  get  away  from  the  delusion  that 
every  item  in  a  trial  balance  must  be  transferred  to  a  bal- 
ance sheet. 

The  author  does  not  advocate  a  change  in  the  present 
system  merely  because  it  has  been  demonstrated  time  and 
time  again  that  bankers  and  business  men  want  some 
other  form  of  statement  than  that  which  has  been  thrust 
upon  them  by  accountants  who  are  still  only  bookkeepers, 
but  because  the  scientific  manner  of  presentation  is  that 
which  reduces  figures  to  readable  form  and  which  dis- 
closes facts  rather  than  book  balances. 

This  form  of  statement  may  be  considered  crude  by 
the  technical  auditor,  but  the  author  ventures  the  opinion 
that  if  it  is  presented  to  one  hundred  business  men,  side 
by  side  with  the  usual  debit  and  credit  form  of  balance 
sheet,  ninety-nine  will  express  an  immediate  and  emphatic 
preference  for  the  one  tiow  shown. 

There  are  several  unsound  features  about  the  form 
which  will  be  noted  by  the  professional  auditor.     For  ex- 


270  '  AUDITING 

ample,  the  question  ''Value  of  merchandise  on  hand  at 
cost"  is  practically  an  invitation  to  overvalue  the  mer- 
chandise, as  most  concerns  hold  goods  which  should  be 
inventoried  at  less  than  cost.  A  much  better  form  appears 
on  pages  258-263. 

CREDIT  STATEMENT  RECOMMENDED  BY  NATIONAL 
ASSOCIATION   OF   CREDIT  MEN 

To 

For  the  purpose  of  obtaining  credit  now  and  hereafter  for  goods 
purchased,  we  herewith  submit  to  you  the  following  statement  of  our 
resources  and  liabilities,  and  will  immediately  notify  you  of  any  material 
change  in  our  financial  condition. 

In  consideration  of  your  granting  credit  to  the  undersigned,  we 
agree  that  in  case  of  our  failure  or  insolvency,  or  in  case  we  shall 
make  any  assignment  for  the  benefit  of  creditors,  bill  of  sale,  mortgage, 
or  other  transfer  of  our  property,  or  shall  have  our  stock  or  plant 
attached,  receiver  appointed,  or  should  any  judgment  be  entered 
against  us,  then  all  and  every  of  the  claims  which  you  have  against  us 
shall  at  your  option  become  immediately  due  and  payable,  even  though 
the  term  of  credit  has  not  expired.  All  goods  hereafter  purchased 
from  you  shall  be  taken  to  be  purchased  subject  to  the  foregoing  con- 
ditions as  a  part  of  the  terms  of  sale. 


CERTIFICATES    AND    REPORTS 


271 


Active  Business  Assets 

Value  of  merchandise  on  hand  at  cost 

If  manufacturing,  raw  material,  $ , 

finished,  $ '. unfinished,  $ 

Notes  and  accounts,  cash  value 

Cash  in  hand 

Cash  in  bank 

Bills  or  accounts  receivable,  due  from  officers. 

Patents  and  patterns 

Fixtures  and  machinery 

Total  real  estate,  cash  value $ 

Total  encumbrances  on  real  estate,  $ , 

Equity , 


Total  Active  Business  Assets. 
Business  Liabilities 


Owe  for  merchandise,  open  acct., 

of  which  $ is  past  due 

Owe  for  notes  for  merchandise 

Owe  banks 

Owe  for  bills  for  paper  sold. . . 
Owe  others  for  borrowed  money 

Owe  taxes  and  rent 

Mortgages  on  fixtures  &  mach'y 


Dollars 


Cts. 


Total  Business  Liabilities 

Net  Worth  .in  Business 

Name  in  Full         OFFICERS 

President 

Vice-President 

Secretary  

Treasurer ... 


Dollars 


Cts. 


Address 


DIRECTORS 


.  f  Accommodation  Indorsements 

Contmgent  J  indorsed  Bills  Receivable  and  Outstanding. 
Liability     j 


Authorized  Capital 

Subscribed Paid  in . 

How  paid  in :  Cash,  $ 

Other  property 


2J2 


AUDITING 


Incorporated  in  what  State  and  under  what  General  Laws  or  Special 

Act? 

Nature  of  business  ? 

Date  of  charter  ?. 

Suits  pending,  and  of  what  nature  ? 


Are  any  merchandise  creditors  secured  in  any  way? 

Amount  of  annual  business 

Annual  expenses Annual  dividends 

When  was  last  dividend  declared  ? 

Rate Insurance  carried  on  merchandise. 

On  fixtures  and  machinery On  real  estate. 

Regular  time  of  taking  inventory 

Keep  bank  account  with 


Keep  the  following  books  of  account. 


If  you  have  pledged  or  transferred  outstanding  accounts  or  property 
remaining  under  your  control,  state  amount  thereof  and  amount  re- 
ceived, or  to  be  received,  on  account  of  such  pledge  or  transfer 


Remarks 


The  above  statement,  both  printed  and  written,  has  been  carefully 
read  by  the  undersigned,  and  is  a  full  and  correct  statement  of  our 

financial  condition  as  of 191 . . . 

Dated 191 . .      Corporation  Signature 

Town State By 

Liens  and  Hypothecations 

Instances  have  been  known  where  certified  balance 
sheets  have  gone  out  wherein  accounts  receivable  and 
merchandise  inventories,  included  among  the  assets  with- 
out any  qualification,  have,  as  a  matter  of  fact,  been 
pledged  as  security  for  loans,  and  thus  were  not  assets  in 
the  sense  which  anyone  making  use  of  the  balance  sheets 
had  a  right  to  assume. 

A  concern  might  have  accounts  receivable  of  $10,000 
and  stock-in-trade  of  $10,000,  with  accounts  and  bills 
payable  of  $15,000.  If  the  latter  were  entirely  unsecured, 
a  prospective  creditor  might  extend  further  credit  if  the 


CERTIFICATES    AND    REPORTS  273 

concern's  standing  were  good,  on  the  theory  that  in  the 
event  of  bankruptcy  there  could  be  a  shrinkage  in  the 
assets  of  25  per  cent  before  a  creditor  would  lose  anything. 

But  suppose  it  were  found  that  all  of  the  accounts 
receivable  had  been  assigned  to,  and  a  chattel  mortgage 
on  the  stock  taken  by,  a  creditor  for  $10,000.  This  would 
mean  that  in  bankruptcy  the  unsecured  creditors  would 
probably  receive  nothing. 

The  professional  auditor  must  never  certify  to  a  balance 
sheet  zmthout  fully  considering  the  possibilities  of  liens  upon 
the  assets,  and  if  any  are  discovered,  such  liens  must  be 
plainly  indicated  on  the  face  of  the  balance  sheet  or  men- 
tioned in  the  certificate,  otherwise  he  is  guilty  of  suppressing 
material  information  and  -can  probably  be  held  responsible  in 
damages  to  anyone  relying  thereon  zvho  suffers  loss  in 
consequence. 

If  there  is  any  difficulty  in  securing  information  of  this 
nature,  the  auditor  may  have  to  ask  the  question  shown 
in  the  credit  men's  standard  form.  If  he  finds  no  trace  of 
liens,  and  the  of^cers  or  partners  state  in  writing  that 
there  are  none,  then  he  could  not  be  held  guilty  of  negli- 
gence. It  would  not  do,  however,  to  rely  on  not  finding 
any  evidence;  there  should  be  af^rmative  proof  that  no 
liens  exist. 

PROFIT  AND  LOSS  STATEMENT 

A  profit  and  loss  statement  is  one  which  assembles  all 
of  the  income  and  expenses,  or  gains  and  losses,  for  a 
stated  period.  It  is  synonymous  with  the  ^'Revenue" 
statement  sometimes  presented,  but  as  the  term 
''Revenue"  is  more  frequently  used  to  designate  one  side 
only  of  a  profit  and  loss  account,  the  term  is  not  properly 
applicable  to  a  statement  which  includes  expenses  as  well 
as  income. 


274 


AUDITING 


The  profit  and  loss  statement  may  be  divided  into  as 
many  sections  as  are  desirable  or  necessary.  The  stu- 
dent of  accountancy  is  usually  taught  to  prepare  the  profit 
and  loss  statement  in  two  sections,  the  first  being  a  trad- 
ing or  a  manufacturing  account,  the  second  section  being 
called  the  general  profit  and  loss  account.  This  illustrates 
the  principles  of  grouping  and  enables  percentages  to  be 
calculated  which  are  extremely  valuable  for  comparative 
purposes.  The  trading  or  manufacturing  account  usually 
shows  on  one  side  net  sales,  and  on  the  other  prime  costs 
of  sales;  i.e.,  materials  used,  labor,  and  other  direct 
expenses.  In  some  cases  other  expenses  are  included, 
such  as  rent,  interest,  taxes,  etc. 

In  modern  practice  it  is  not  customary  to  submit  a 
trading  or  a  manufacturing  account  under  these  captions. 
The  experienced  auditor  or  accountant  compiles  a  profit 
and  loss  account  suited  to  the  requirements  of  each  enter- 
prise upon  which  he  is  reporting,  and  in  a  form  under- 
standable to  those  who  are  to  use  the  report. 

The  following  condensed  form  of  profit  and  loss  state- 
ment was  submitted  to  the  St.  Louis  Congress  of  Ac- 
countants in  1904  by  A.  Lowes  Dickinson,  C.P.A.: 

Gross  Earnings  (whether  sales  of  products,  transportation 

earnings,  professional  earnings,  etc.)         .        .        .        .    $.... 

Deduct — Cost  of  Manufacture  or  Operation : 

^a)  Manufacture  (for  a  manufacturing  concern) 

Labor  $ 

Material        

General  Manufacturing  Expenses     

(b)  Cost  of  Operation  (for  concerns  not  manufacturing)  : 
(Under  suitable  headings  according 
to  the  nature  of  the  business)        


Gross  Profits     . 
Other  Earnings 


CERTIFICATES    AND    REPORTS  275 

Deduct : 
Expenses  of  Sale  (manufacturing  business 

only)  $ 

Expenses  of  Management  (if  distinct  from 

operation)  

Net  Profits  from  operations $ 

Deduct : 

Interest  on  Bonds $ 

Other  Fixed  Charges 

Surplus  for  the  year $ 

Extraordinary  Profits  (detailed)  

Surplus  brought  forward  from  preceding  year 

Deduct:  ^ 

Extraordinary  Charges  not  applicable  to 

the  operations  of  the  year        .        .        .    $ 

Interest  and  Dividend  on  Stocks         

Surplus  carried  forward $ 

Where  further  information  is  required  the  condensed 
statement  is  supported  by  schedules  or  exhibits  which  go 
into  as  much  detail  as  may  be  necessary. 

The  auditor  should  strive  so  to  arrange  the  accounts 
as  to  show  a  comparison  with  previous  periods;  also, 
wherever  the  nature  of  the  business  permits,  unit  costs  or 
earnings  should  be  shown.  For  instance,  the  accounts 
of  a  taxicab  company,  if  properly  set  up,  will  show  the 
average  gross  earnings  of  cabs  per  day.  They  will  also 
show  the  operating  cost  per  mile.  Perhaps  the  simplest 
illustration  is  a  blast  furnace.  Here  it  is  relatively  easy  to 
determine  the  cost  of  producing  a  ton  of  pig  iron,  but  the 
figures  would  be  of  little  value  unless  the  output  were 
shown  with  the  average  cost.  The  production  for  one 
week  might  be  10,000  tons  and  the  average  cost  $8  per 
ton;  the  next  week  if  the  production  were  15,000  tons 
and  the  cost  $8  per  ton,  the  natural  inquiry  would  be: 


276  AUDITING 

Why  is  the  cost  not  proportionately  less  upon  the  greater 
output?  If  the  cost  per  ton  were  reported  separately  from 
the  production,  attention  might  not  be  called  to  the  possi- 
bility of  lower  costs  being  in  order. 

The  relation  which  each  class  of  expense  bears  to  the 
total  volume  of  business  is  always  interesting.  In  dull  times 
it  may  be  expected  that  certain  so-called  fixed  charges 
will  not  vary,  but  there  are  other  classes  of  expenses  which 
should  fluctuate  ratably  with  the  volume  of  business. 

The  auditor  who  states  the  accounts  of  a  number  of 
concerns  in  the  same  line  of  business  can  readily  acquire 
a  knowledge  of  income  and  costs  which  he  may  impart 
for  the  benefit  of  all  at  the  expense  of  none.  He  must 
not  divulge  to  one  client  the  afTairs  of  another,  but  if  he 
ascertains  that  the  office  staff  of  one  wholesale  grocer 
costs  1  per  cent  per  annum  of  the  sales,  while  another 
costs  one-half  of  1  per  cent  and  is  equally  or  more  efficient, 
he  certainly  is  justified  in  making  a  special  investigation 
into  the  matter,  and  cannot  be  criticized  for  reporting 
that  1  per  cent  is  excessive. 

Use  of  Charts  and  Graphs 

The  use  of  charts  by  engineers  probably  dates  back 
to  the  early  days  of  that  profession;  likewise,  the  use  of 
charts  by,  accountants  can  be  traced  back  many  years. 
Their  use,  however,  is  by  no  means  general,  although 
there  are  occasions  when  a  chart  can  portray  a  situation 
far  more  graphically  than  columns  of  figures,  particularly 
to  a  man  who  is  more  used  to  blue  prints  than  to  accounts. 
In  such  cases  the  effectiveness  of  a  report  is  greatly  increased 
by  thus  picturing  the  figures. 

Sales  Charts 

An  effective  use  of  charts  can  be  made  in  a  wholesale 
or  retail  trading  concern  where  the  question  of  compari- 


CERTIFICATES    AND    REPORTS 


277 


sons  IS  of  great  importance.  A  chart  can  be  prepared  at 
the  commencement  of  a  fiscal  year  showing  the  compara- 
tive sales  by  months  and  the  cumulative  totals  for  the 
preceding  year,  e.g.: 


28 


?   e   I  I 


ri~~rgi 


280 


nOQ  MONTHLY  5ALES  CURVES,  USE  SCALE  ON  THE  LEPT. 

FOa.  ACCUMULATED  SALES  CURVES,  USE  SC^LE  ON  THE  RIGHT 


It  will  be  noted  from  the  above  that  during  the  pre- 
ceding year  the  monthly  sales  in  February  were  $14,000, 
going  up  to  $18,000  in  June,  down  to  $16,000  in  Septem- 
ber, up  to  $19,000  in  December,  and  down  to  $17,000  in 


278 


AUDITING 


January.  These  figures  are  shown  by  the  dotted  black 
line.  The  new  year  (solid  line)  commences  with  $16,000, 
a  gain  over  the  previous  year,  as  clearly  shown  by  the 
chart.  In  May  the  increase  is  not  only  maintained,  but 
the  rate  of  gain  is  increased. 

In  other  words,  a  chart  will  show  a  trend  which  col- 
umns of  figures  fail  to  emphasize.  The  best  place  for  a 
chart  of  this  kind  is  on  the  wall  of  an  office  or  on  a  map 
holder.  It  may  be  kept  private  by  having  a  cover  over  it, 
or  it  may  be  rolled  up.  The  auditor  may  submit  a  sample 
chart,  based  on  past  experience,  which  will  indicate  the 
possibilities  of  the  plan. 

Gross  and  Net  Profit  Charts 

It  is  sometimes  difficult  for  a  business  man  to  calcu- 
late how  much  gross  profit  he  must  make  to  cover  his 
general  expenses.  The  use  of  a  chart  will  assist  him  to 
solve  his  problem. 

The  chart  opposite  illustrates  the  fact  that  in  any 
business  there  is  a  point  above  which  increases  in  sales 
return  a  net  profit  greater  proportionately  than  the  in- 
crease in  sales.  In  other  words,  above  a  certain  point  any 
increase  in  sales  occasions  an  increase  in  direct  cost,  but 
does  not  necessarily  increase  the  overhead  or  indirect 
expense  at  all.  The  result  is  that  the  percentage  of  profit 
is  greater. 

The  chart  shows  that  from  January  to  June  cost  and 
expenses  were  increasing,  and  that  when  the  slump  in 
sales  came  in  July  and  August,  the  expenses  were  not 
reduced  in  proportion.  The  result  was  that  in  September 
the  sales  were  just  enough  to  cover  cost  and  expenses. 
Had  the  expenses  been  kept  down  to  the  point  at  which 
they  started  in  January,  the  reduction  in  direct  cost  due 
to  the  decrease  in  sales  would  have  kept  the  total  cost 


CERTIFICATES    AND    REPORTS 


The  lower 


well  below  the  low  point  reached  by  the  sales, 
line  represents  the  net  profit  realized. 

It  will  be  noticed  from  the  chart  on  this  page  that 
whenever  the  gross  sales  are  above  $10,000  per  month, 
the  net  profit  increases  rapidly,  and  below  $10,000,  the 
net  profit  drops  at  once.  After  a  little  experience  the 
business  man  will  be  able  to  see  the  danger  mark. 


12 
n 

K> 

9 

38 

0  7 

L 

A 
3 
2 

1 
0 

/ 

\, 

i 

• 

SAV.tS 

'^ 

\ 

\. 

/ 

"*"*"> 

/ 

-^ND  fi 

\ 

\ 



-^ 

C^ 

^ 

J^ 

^ 

^Rt/y, 

ai. 

/ 

-^ 

lAf^ 

^f' 

^V 

\ 



k 

\ 

.-^ 

2 
i 

FEB 
MAR 
APR 
MAY 
JUN. 
JUL 
AUG 
5ER 
OCT. 
NOV 

28o 


AUDITING 


Combined  Purchase  and  Sales  Charts 

If  business  is  not  good  purchases  may  represent  an 
unnecessary  risk  as  compared  with  sales.  A  chart  would 
show  the  sales  and  purchases  month  by  month,  thus  giving 
instant  expression  to  an  expansion  of  one  against  a  con- 
traction of  the  other,  as  shown  below. 


170 

160 

.     |- 

d  ^ 

fe  13C 

|l20 

fllO 

100 

to 

/ 

/ 

\ 

—5^ 

-ES 

/ 

. ' 

^ 

/ 

,^-^^' 

rrr 

^ 

/ 

90 

.tj-/' 

^-^ 

.^^' 

r 

J 

1 1 

1 1 

r ■ 

• 

PER 
MAR. 
APR. 
MAY 
JUK 
JUL. 

SEP 
OCT. 

NOV. 

i 

It  will  be  noted  that  in  June  the  sales  fell  off,  but  that 
the  purchases  kept  up  the  regular  advance,  and  that  by 
November  the  sales  were  actually  less  than  the  purchases, 
indicating  an  enormous  increase  in  the  inventory.  If  the 
chart  had  been  kept  up  to  date  the  proprietor  would  have 
noticed  the  trend  in  July  and  purchases  might  have  been 
cut  down  at  once. 

It  may  be  objected  that  a  good  business  man  always 


CERTIFICATES    AND    REPORTS 


281 


keeps  in  touch  with  such  important  matters  and  that 
while  such  a  chart  might  be  of  interest  to  him  it  would 
have  no  practical  value.  This  is  true  of  many  men,  but  it 
is  not  true  of  the  many  who  have  such  a  poor  clerical 
staff  that  they  cannot  depend  on  their  results,  or  those 
who  ignore  book  figures  because  they  are  not  able  to 
understand  the  monthly  "trial  balances"  which  they 
receive. 

Charts  like  the  above  can  be  kept  up  day  by  day  so  far 
as  sales  are  concerned.  As  to  purchases,  all  depends  on 
the  method  of  entering  invoices.  If  compiled  monthly 
only,  of  course  the  chart  can  be  posted  only  once  a  month, 
but  if  it  is  looked  after,  say,  by  the  10th  of  each  month, 
it  will  then  be  sufficiently  up-to-date  to  be  of  substantial 
value. 


Preparation  of  Charts 

As  a  result  of  invitations  extended  by  The  American 
Society  of  Mechanical  Engineers,  a  number  of  associations 
of  national  scope  appointed  representatives  on  a  "Joint  Com- 
mittee on  Standards  for  Graphic  Presentation."  The  com- 
mittee made  a  study  of  the  methods  used  in  the  different 
fields  of  endeavor  for  presenting  population 
statistical  and  quantitative  data  in 
graphic  form,  and  recommended 
the  following  simple  and  convenient 
standards  to  be  used  in  the  prepara- 
tion of  charts : 

1.  The  general  arrangement  of 
a  diagram  should  proceed  from  left 
to  right. 


ioo.000.000 

80.000.000 
60.000.000 


40,000.000 

20.000.000 


I  S  S  S  8  8  8  2 


Fig.  1 


282 


AUDITING 


2.  Where  possible,  represent  quantities  by  linear  mag- 
nitudes, as  areas  or  volumes  are  more  likely  to  be 
misinterpreted. 

Year         Tons 
1900.      270,588  HB  I 1 

nU    DO 


1914.       555.031 


U 


Fig.  2 

3.  For  a  curve,  the  vertical  scale,  whenever  practicable, 
should  be  so  selected  that  the  zero  line  will  appear  on  the 
diagram. 

4.  If  the  zero  line  of  the  vertical  scale  will  not  nor- 
mally appear  on  the  curve  diagram,  the  zero  line  should 
be  shown  by  the  use  of  a  horizontal  break  in  the  diagram. 


Sales 

$  1000 
900 


f 


too 

■" 

y 

98 
97 
96 

^ 

y 

y-A 

«.- 

— ' 

' 

95 

rj — 1 — rn — r^ 

1 

0 

E 

c 

L 

C 

1  1 

2  3  4   5  6  7  8  9  \0  H  U 

Months 


Fig.  3 


E     3     4     5     6     7 

Hours 


Fig.  4 


5.  The  zero  lines  of  the  scales  for  a  curve  should  be 
sharply  distinguished  from  the  other  co-ordinate  lines. 


y 

/ 

y 

s. 

X 

^ 

■^ 

"^ 

T 

A 

i-^ 

5.? 

3  y 

3.S 
fea 

5  c 
r 

5  .c 

s.< 

3 

Fig  5c 


CERTIFICATES    AND    REPORTS 


283 


6.  For  curves  having  a  scale  representing  percentages, 
it  is  usually  desirable  to  emphasize  in  some  distinctive  way 


%SSl 


"" 

~" 

^ 

^ 

^ 

^ 

^ 

/^ 

^ 

^ 

1' 

i?i 

Y 

sar 

n 

*l? 

Relative 
Cost 

104 
IDS 
102 
K)l 
100 
99 
96 
97 


:==;;!eU 


^ 


Fig.  6a 


-■'Year'        ' 
Fig.  6b 


Percent 

of 
People 

too 

90 

eo 

70 
60 
50 
40 
30 
20 
10 


r 


~ 

" 

" 

- 

■; 

? 

? 

/ 

/ 

J 

/ 

/ 

/ 

- 

? 

^ 

^ 

/^ 

- 

- 

7 

/ 

/ 

i 

/ 

i 

^ 


Pep  Cent  of  Income 
Fig.  6c 


the  100  per  cent  line  or  other  line  used  as  a  basis  of 
comparison. 


7.  When  the  scale  of  a 
diagram  refers  to  dates,  and 
the  period  represented  is  not 
a  complete  unit,  it  is  better 
not  to  emphasize  the  first 
and  last  ordinates,  since  such 
a  diagram  does  not  represent 
the  beginning  or  end  of 
time. 

8.  When  curves  are 
drawn  on  logarithmic  co- 
ordinates, the  Hmiting  lines 
of  the  diagram  should  each 
be  at  some  power  of  ten  on 
the  logarithmic  scales. 


Population 


I  a  8  e  8 .»  I  2 

Year      ' 
Fig.  7 


Population 

100,000,000 


t.000,000 


Year 

Fig.  8 


284 


AUDITING 


9.  It  is  advisable  not  to  show  any  more  co-ordinate 
lines  than  necessary  to  guide  the  eye  in  reading  the 
diagram. 


Population 

too.ooo.ooo 


\ 


I  8  s  F  s  S5  i  ^ 
Year 

Fig.  9a 


Population 

"* 

—  yi  .- 

60.000.000 

A     * 

0     I   ■   mn   I   I    J 

|SS?SS?82 

Fig.  9b 


=^ 


8  2^8882 
■  Year      * 

Fig.  10 


10.  The  curve  lines  of  a 
diagram  should  be  sharply 
distinguished  from  the  rul- 
ing. 

11.  In  curves  represent- 
ing a  series  of  observations, 
it  is  advisable,  whenever  pos- 
sible, to  indicate  clearly  on 
the    diagram   all   the    points 


representing  the  separate  observations. 


Population 


ao.(»D.oao  - 

60.000.000  - 
«)AX>.OQO  - 
20.000.00   > 

0     L 


I  »  S  ?  .8  9  8  .2 
Year      " 

Fig.  11a 


Days 


Fig.  lib 


20      2%       30 


^  t  S  S  R  S8S 

Speed  RPM 


Fig.  lie 


CERTIFICATES    AND    REPORTS 


285 


12.  The  horizontal  scale 
for  curves  should  usually  read 
from  left  to  right,  and  the 
vertical  scale  from  bottom  to 
top. 

13.  Figures  for  the  scales 
of  a  diagram  should  be  placed 
at  the  left  and  at  the  bottom, 
or  along  the  respective  axes. 


Population 

tnn  fwn  iwm 

^    80,000.000 

^ 

/ 

/ 

/ 

20,000.to 
0 

.^ 

^ 

^ 

Fig.  12 


Population 

100.000.000 


80.000.000 
60.QCO.a0O 


;:*: 


wss 

$2,000 
1,500 
1,000 

soo 

0 

500 
1.000 
1,500 


^.,,^.,i.=    ri 


> 

/^ 

< 

V. 

y 

T 

1 

i-^ 

5  J 

S.J 

3; 

if 

r 

3  i 

3.S 

Fig.  13a 


Fig.  13b 


L 


Fig.  13c 


14.  It  is  often  desirable  to  include  in  the  diagram  the 
numerical  data  or  formulae  represented. 


.5  £  a  K  8  s 


100.0Q0.000 

60.000.000 
60.000.000 
40,000.000 
20.000.000 
0 


/ 

/ 

/ 

/ 

X 

^ 

g    c 
I-" 

H  i 

8  / 

r 

fi  i 

1° 

Fig.  14a 


r 


2!::'8SS 


^     s 

.^     ^. 

^-^     /         % 

12345678910  II  12 

Month 


Fig  14b 


fi 


0    12    3   4    5    6    7 

X 


Fig.  14c 


286 


AUDITING 


15.  If  numerical  data  are  not  included  in  the  diagram 


it  is  desirable  to  give  the  data  in  tabular 
form  accompanying  the  diagram. 


Population 


r 


lUU.UUU.UUU 

fiOOOQQQQ 

/ 

€0^000.000 

20.000,000 
0 

/ 

/ 

/ 

^ 

y 

^ 

^ 

S  S  ^  S  8  8  2 
-    -    -    -    -     ^  , 


Yean 

Population 

1840 

1850 

1860 

<870 

1880  1 

1890 

1900 

1910 

17,069,453 
23,191  876 
31,443.321 
38,556;371 
50,155,783 
62,622,150 
75,994,575 
91,972,266 

Year 


Fig.  15 


16.  All  lettering  and  all  figures  on  a  diagram  should 
be  placed  so  as  to  be  easily  read  from  the  base  as  the 
bottom,  or  from  the  right-hand  edge  of  the  diagram  as 
the  bottom. 

lY.  The  title  of  a  diagram  should  be  made  as  clear  and 
complete  as  possible.  Subtitles  or  descriptions  should 
be  added  if  necessary  to  insure  clearness. 


.<or>o<u  —  'Aii«ooco 


Population 

100,000,000 


-<jJ^SAil8:S5?S52t8m 


200 
160 
160 
140 
120 
100 
60 
60 
40 
20 
0 


I   2  3  4  5  6  7  8  9  W  II  12 1 

Month 

Aluminum  Castings  Output 
of  Plant  No.  2,  by  Months, 
1915.  Output  Is  Given  in. 
Short  Tons.  Sales  of  Scrap 
Aluminum  Are  Not  In- 
cluded. 

Fig.  17 


CERTIFICATES    AND    REPORTS  287 

The  auditor  who  desires  suggestions  relative  to  the 
preparation  of  charts  for  various  purposes,  should  con- 
sult "Graphic  Methods  for  Presenting  Facts,"  by  Willard 
C.  Brinton.  The  following  quotation  is  taken  from  this 
book: 

Accurate  data  and  real  facts  are  valuable.  But  when  it  comes  to 
getting  results,  the  manner  of  presentation  is  ordinarily  more  important 
than  the  facts  themselves.  Unless  the  facts  are  presented  in  a  clear 
and  interesting  manner,  they  are  about  as  effective  as  a  phonograph 
record  with  the  phonograph  missing. 

Men  who  realize  how  much  depends  upon  the  method  of  presenting 
facts  as  compared  with  the  facts  themselves  use  graphic  methods  when- 
ever possible.  Executives  can  save  themselves  a  vast  quantity  of  use- 
less brain  work  and  have,  at  the  same  time,  a  better  grasp  on  their  busi- 
ness if  they  require  reports  and  operating  figures  to  be  submitted  in  the 
graphic  form  of  diagrams  and  curves. 

When  figures  are  put  in  graphic  form,  not  only  is  there  a  great 
saving  in  the  time  of  the  reader,  but  there  is  an  infinite  advantage  in 
that  he  can  absorb  more  facts  with  less  danger  of  misinterpretation. 

Value  of  Comparative  Statistics 

The  head  of  the  fidelity  department  of  one  of  the 
large  surety  companies  states  that  a  great  many  irregu- 
larities and  defalcations,  especially  through  the  padding 
of  pay-rolls,  would  be  uncovered  in  their  infancy  if  the 
managements  of  factories  and  commercial  business  houses 
would  pay  more  attention  to  their  accounts  and  have 
compiled  by  their  accounting  department  comparative 
statistics  of  their  business — and  then  study  them.  He 
cites  the  case  of  a  cashier  of  a  manufacturing  concern 
who  had  been  padding  the  pay-roll  for  years.  It  was  the 
practice  of  this  concern  to  have  the  pay-roll  approved  by 
the  foreman,  the  superintendent,  and  the  general  man- 
ager. It  would  then  be  sent  to  the  cashier,  who  made 
alterations  in  the  total  figures,  drew  a  cheque  for  the 
raised  amount,  cashed  it,  and  paid  ofif  the  men.     The 


288  AUDITING 

pay-roll  did  not  leave  the  cashier  after  it  was  given  to 
him  to  draw  the  cheques,  he  making  the  distribution  for 
posting.  This  went  on  for  years,  the  cashier  each  week 
pocketing  from  two  to  nine  hundred  dollars,  until  a 
change  of  executives  brought  in  a  manager  who  had  been 
accustomed  to  getting  his  accounts  down  so  as  to  show 
the  economic  condition  of  his  business  in  statistical  form. 
He  had  been  in  the  same  line  before  and  he  knew  that  the 
price  of  raw  material,  the  rates  for  wages,  and  the  various 
expenses  were  about  the  same  as  in  his  former  place,  but 
the  profit  and  loss  account  showed  a  much  smaller  net 
profit.  It  was  soon  found  that  this  was  due  to  the  high 
charge  for  labor,  and  upon  analysis  of  this  charge  the 
stealings  were  discovered. 

This  is  but  one  instance,  but  it  is  not  hard  to  see  that 
in  showing  the  results  of  a  business  in  graphic  form  so 
that  the  relation  of  the  various  elements,  one  to  another, 
is  easily  seen,  abnormal  conditions  are  at  once  detected. 
Some  men  will  say  that  those  things  are  interesting  and 
all  very  well  if  one  had  the  time  and  money  to  get  them 
up.  They  do  not  realize  the  cost  of  not  getting  them  up. 
Statistics  compiled  by  one  of  the  large  bonding  companies 
show  that  during  the  last  three  weeks  of  March  and  the 
month  of  April,  1911,  shortages  amounting  to  more  than 
one  half  million  dollars  were  discovered  in  mercantile 
houses  alone. 

What  Not  to  Report 

As  heretofore  stated,  it  is  not  wise  to  report  unimpor- 
tant errors,  etc.,  first,  because  it  accomplishes  no  useful 
purpose,  if  true.  In  any  event  criticisms  of  this  nature 
should  never  be  made  without  confirmation  from  the  office 
stafif,  as  they  might  be  able  to  come  back  with  proof  that 
the  errors  or  omissions  were  apparent  only. 


CERTIFICATES    AND    REPORTS  289 

Likewise,  long  schedules  of  trade  debtors  and  creditors 
are  superfluous.  For  some  years  public  accountants  made 
it  a  rule  to  furnish  their  clients  with  detailed  schedules 
of  accounts  receivable  and  payable,  believing  that  such 
information  was  desired  by  them  and  would  be  of  value. 
They  found,  however,  that  in  nine  cases  out  of  ten  these 
schedules  were  not  referred  to,  and  in  the  one  case  remain- 
ing the  schedules  desired  were  the  latest  ones  rather  than 
the  ones  submitted  by  the  auditors,  which  were  usually 
one  or  two  months  old.  The  practice  was,  therefore, 
quite  generally  abandoned,  and  these  schedules  are  now 
furnished  only  on  request. 

In  reports  where  special  circumstances  govern,  such 
as  changes  in  partnership,  it  may  be  necessary  to  submit 
detailed  schedules.  But  the  above  remarks  refer  to  the 
ordinary  periodical  audit. 

A  schedule  of  vouchers  and  paid  cheques  not  sub- 
mitted is  sometimes  of  importance,  but,  as  a  rule,  it  is 
more  desirable  to  prepare  such  a  list  before  the  end  of  the 
audit  and  hand  a  duplicate  to  the  bookkeeper,  so  that 
the  missing  vouchers  may  be  located.  After  as  many  as 
possible  are  located,  the  corrected  list  should  be  handed 
to  the  proprietor  with  a  request  that  he  look  over  it.  If 
further  inquiry  or  search  is  requested,  it  should  be  made 
before  the  audit  is  completed.  If  no  further  attention  is 
required,  the  schedule  is  not  important  enough  to  put  in 
a  report. 

The  auditor  should  scan  the  list  of  outstanding  unpaid 
bank  cheques.  A  cheque  is  sometimes  issued  to  close  a 
disputed  account,  etc.,  which  renders  it  desirable  from 
both  the  client's  and  the  auditor's  point  of  view  that  it  be 
used.  The  inspection  would  apply  only  to  those  outstand- 
ing an  unreasonable  length  of  time.  If  any  doubt  arises 
the  matter  should  have  attention  at  once,  and  no  mention 


29P  AUDITING 

need  be  made  in  the  report  unless  some  irregularity  is 
discovered. 

Restrictions  on  Client's  Use  of  Reports 

Mention  has  been  made  of  attempted  unauthorized 
use  of  auditors'  reports  and  certificates.  This  is  obviated 
by  a  judicious  selection  of  clients,  but  it  may  happen  that 
a  client  who  has  paid  for  a  report  will  feel  at  Hberty  to  use 
part  of  the  contents  without  disclosing  the  context. 
Anticipating  this  possibility,  experienced  auditors  bind 
and  fasten  their  reports  securely  together,  and  page  them 
in  such  a  way  that  a  part  cannot  be  used  without  reveal- 
ing the  fact  that  it  is  not  complete. 

It  does  not  seem  feasible  to  suggest  any  plan  whereby 
clients  or  others  may  be  prevented  from  quoting  from  a 
report.  So  long  as  the  statement  is  not  made  that  the 
quotation  represents  conclusions  of  fact  to  which  an  audi- 
tor has  certified,  it  may  not  be  objectionable,  but  it  is 
remarkable  how  critical  business  men  are  with  respect 
to  the  connection,  or  alleged  connection,  of  a  profes- 
sional auditor  with  men  or  enterprises  of  a  doubtful 
character. 

In  one  case  a  well-known  firm  of  auditors  had  for  many 
years  audited  and  certified  to  the  accounts  of  a  small  and 
prosperous  corporation.  A  large  concern  bought  the  small 
company  and  consolidated  it  with  a  number  of  others. 
The  bankers  who  marketed  the  stock  stated  in  their  cir- 
culars that  the  accounts  of  the  small  company  had  been 
audited  by  one  firm  and  the  accounts  of  all  the  others, 
and  of  the  holding  company,  had  been  audited  by  an 
audit  (stationery)  company.  The  latter  continued  the 
audit  until  the  holding  company  went  into  hopeless  bank- 
ruptcy. The  firm  was  not  connected  with  the  enterprise 
after  its  clients  sold  out,  but  after  the  bankruptcy  a  large 


CERTIFICATES    AND    REPORTS  291 

banking  house  intimated  that  the  mention  of  the  firm's 
name  on  a  circular  relative  to  a  company  with  such  an 
objectionable  history  might  seriously  affect  their  own 
attitude  in  employing  the  firm  for  accountancy  work. 

This  is  an  extreme  case,  but  it  illustrates  the  great 
importance  to  an  auditor  of  restricting  the  use  of  his  name 
to  professional  work  which  is  creditable  to  him  in  every 
way,  and  in  connection  with  clients  or  promoters  who  are 
beyond  suspicion. 

Misleading  Advertisements 

Auditors  are  sometimes  requested  to  compile  data  or 
statistics,  or  prepare  calculations  for  use  in  new  enter- 
prises. Great  care  must  be  taken  to  restrict  the  use  of  the 
reports  submitted  for  such  purposes. 

Recently  an  issue  of  preferred  stock  was  advertised 
and  a  large  bonus  of  common  stock  was  offered  as  an 
inducement  to  purchase.  The  following  statement  was 
made  inter  alia: 

Based  on  reports  of  A  &  B,  certified  public  accountants,  on  manu- 
facturing costs  and  selling  prices  from  six  months'  operation  at  part 
capacity  of  plant  at  Blank  City,  earnings  at  full  capacity  are  esti- 
mated AT  over  35  PER  CENT  ON  THE  COMMON  STOCK  AFTER  PAYMENT  OF 
7  PER  CENT  DIVIDENDS  ON  PREFERRED  STOCK. 

The  intention  of  the  foregoing  was  clearly  to  deceive.  It 
was  so  printed  that  everyone  gathered  the  impression  that 
the  auditors  had  made  a  report,  based  on  which  earnings 
equal  to  35  per  cent  on  the  common  stock  could  be 
expected. 

It  may  become  necessary  for  auditors  to  print  on  their 
stationery  some  form  of  notice  to  the  effect  that  no  public 
use  can  be  made  of  the  information  conveyed  unless  a 
memorandum  setting  forth  the  form  of  the  proposed  use 
is  submitted  for  inspection. 


292  AUDITING 

Compulsory  Reports 

Compared  with  our  lack  of  legal  requirements,  it  is  of 
interest  to  note  the  reports  which  must  be  prepared  in 
England. 

The  following  is  an  extract  from  Table  A  of  the  Eng- 
lish Companies  Act  of  1908: 

Section  106.  Once  at  least  in  every  year  the  directors  shall  lay 
before  the  company  in  general  meeting  a  profit  and  loss  account  for 
the  period  since  the  preceding  account  or  (in  the  case  of  the  first 
account)  since  the  incorporation  of  the  company,  made  up  to  a  date  not 
more  than  six  months  before  such  meeting. 

Section  107.  A  balance  sheet  shall  be  made  out  in  every  year  and 
laid  before  the  company  in  general  meeting,  made  up  to  a  date  not 
more  than  six  months  before  such  meeting.  The  balance  sheet  shall 
be  accompanied  by  a  report  of  the  directors  as  to  the  state  of  the  com- 
pany's affairs,  and  the  amount  which  they  recommend  to  be  paid  by 
way  of  dividend,  and  the  amount,  if  any,  which  they  propose  to  carry 
to  a  reserve  fund. 

Section  108.  A  copy  of  the  balance  sheet  and  report  shall,  seven 
days  previously  to  the  meeting,  be  sent  to  the  persons  entitled  to  receive 
notices  of  general  meetings  in  the  manner  in  which  notices  are  to  be 
given  hereunder. 

Audit:  vSection  109.  Auditors  shall  be  appointed  and  their  duties 
regulated  in  accordance  with  sections  112  and  113  of  the  Companies 
(Consolidation)  Act,  1908,  or  any  statutory  modifications  thereof  for 
the  time  being  in  force. 


CHAPTER    XIV 

THE    DETAILED    AUDIT 


GENERAL   PRINCIPLES 

Completed  Audit 

It  was  stated  on  page  52  that  before  commencing 
an  audit  the  auditor  should  be  furnished  with  a  correct 
trial  balance  as  of  the  closing  date.  This  applies  to  what 
is  known  as  a  completed  audit,  which  is  the  term  usually 
employed  to  designate  the  audit  where  a  complete  fiscal 
or  interim  period  has  elapsed  and  where  a  final  report  is 
to  be  made  on  the  work  accomplished.  The  procedure 
outlined  in  this  and  succeeding  chapters  is  designed  to 
cover  such  a  completed  audit. 

Continuous  Audit 

This  term  applies  to  the  supervision  by  an  auditor 
who  attends  at  intervals  during  a  period,  and  makes  a 
report  of  progress  rather  than  a  report  which  embodies  a 
balance  sheet  and  a  profit  and  loss  account.  In  modem 
practice  this  distinction  receives  little  consideration.  Up- 
to-date  concerns  demand  monthly  reports  of  operations, 
and  monthly  balance  sheets  follow  as  a  matter  of  course. 

The  auditor  who  is  retained  to  audit  the  accounts,  and 
pass  on  or  prepare  these  monthly  reports  may  be  said  to 
make  a  completed  audit,  although  in  some  cases  part  of 
the  audit  work  is  left  until  the  end  of  the  fiscal  period. 

293 


294 


AUDITING 


In  large  enterprises  where  a  detailed  audit  is  made 
the  auditor  may  arrange  to  perform  part  of  the  work 
during  the  term  in  order  to  forestall  congestion  towards 
the  end  of  the  period.  Sometimes  the  client  requests  that 
frequent  visits  be  made  so  that  if  errors  of  principle  or 
clerical  errors  are  being  made  they  can  be  detected  and 
corrected  before  very  much  damage  has  been  done.  It  is 
important,  too,  that  if  fraud  is  being  practiced  it  should 
be  discovered  at  the  earliest  possible  date.  Furthermore, 
frequent  and  unexpected  visits  tend  to  keep  the  cHent's 
staff  up-to-date  in  their  work,  and  carelessness  as  well  as 
actual  errors  may  be  disclosed.  The  moral  effect  is  also 
valuable. 

If  a  large  amount  of  detail  work  is'  to  be  verified, 
it  is  important  that  it  be  completed  as  soon  after  the 
closing  date  as  possible  in  order  that  the  auditor's  report 
may  be  submitted  within  the  shortest  possible  time  there- 
after. 

Where  interim  audits  are  made  and  the  auditor  relies 
in  subsequent  audits  on  the  work  of  previous  visits,  there 
is  a  possibility  of  the  figures  which  he  has  passed  being 
tampered  with  in  order  to  conceal  fraud.  The  author  is 
not,  however,  prepared  to  offer  suggestions  for  the  detec- 
tion of  manipulation  of  accounts  after  they  have  been 
audited.  In  the  preparation  of  a  balance  sheet  and  profit 
and  loss  account,  if  analyses  of  the  accounts  are  made, 
unauthorized  alterations,  if  any,  will  probably  be  revealed. 
As  a  matter  of  fact,  experience  has  demonstrated  that 
such  a  contingency  is  a  remote  one  and  its  possibility  is 
best  guarded  against  by  the  intuition  of  the  auditor  rather 
than  by  his  attempting  to  follow  certain  set  rules. 

Completed  audits  are  fast  supplanting  continuous  au- 
dits and  it  is  deemed  to  be  of  more  importance  here  to 
describe  the  former  fully.     The  auditor  who  masters  all 


THE    DETAILED    AUDIT 


295 


the  essentials  of  a  completed  audit  can  readily  prepare  a 
program  for  a  continuous  audit. 

Auditing  by  Tests  and  Scrutiny 

In  various  sections  of  this  book  the  author  refers  to 
"tests"  or  to  "tests  and  scrutiny."  These  terms  must  not 
be  misunderstood,  particularly  with  reference  to  detailed 
audits.  The  fact  must  be  faced  that  in  a  business  of  any 
considerable  size  it  is  a  physical  impossibility  for  the 
auditor  to  verify  every  entry  in  the  books  within  a  reason- 
able period  of  time,  nor  is  it  necessary  in  most  cases,  even 
where  carelessness  and  fraud  exist. 

The  following  definitions  of  the  word  "test"  indicate  its 
scope : 

1.  To  try  by  subjecting  to  some  experiment,  or  by 

examination  and  comparison;  to  subject  to  con- 
ditions that  disclose  the  true  character  of. 

2.  An  examination  made  for  the  purpose  of  proving 

or  disproving  some  matter  in  doubt. 

Using  the  word  "test"  in  this  broad  sense  the  auditor 
will,  by  experience,  learn  to  cut  out  unnecessary  and  time- 
consuming  work  and  to  substitute  therefor  necessary  and 
constructive  work. 

In  some  cases  tests  of  certain  periods  or  certain  quan- 
tities are  suggested  as  justifying  the  conclusion  that  the 
transactions  during  other  periods  and  of  other  quantities 
are  correct,  if  no  errors  are  found  in  the  tests.  This, 
however,  does  not  always  relieve  the  auditor  from  the 
duty  of  scrutinizing  the  transactions  of  the  uncovered 
period,  and  the  unverified  quantities.  As  to  this  condi- 
tion, the  word  "scrutiny"  is  used  as  supplementary  to  the 
word  "test." 

The  time  consumed  in  verifying  in  detail  .all  items 
within  a  limited  period  may  be  considerable,  but  an  ex- 


296    .  AUDITING 

perienced  auditor  can,  within  a  much  shorter  time  rela- 
tively, scan  the  unverified  items  for  unusual  items  or  sus- 
picious entries.  It  is  confidently  predicted  that  an  audit 
program  founded  upon  a  proper  appreciation  of  these 
principles  will  disclose  any  practice  subject  to  criticism. 

THE  AUDIT  OF  INCOME  AND  EXPENSES 

General  Principles 

There  are  two  underlying  principles  which  govern  the 
procedure  in  the  detailed  audit  of  income  and  expenses. 

1.  The  auditor  must  ascertain  whether  the  earnings 
shown  by  the  books  are  properly  accounted  for, 
and  whether  any  of  the  earnings  are  omitted 
therefrom. 

2-.  He  must  ascertain  whether  or  not  the  expenses 
and  losses  are  properly  stated  and  supported. 

At  the  commencement  of  a  detailed  audit  it  is  impor- 
tant for  an  auditor  to  investigate  thoroughly  the  relation 
of  the  clerical  staff  to  the  work  and  to  each  other.  Audi- 
tors are  fond  of  stating  that  a  cashier  should  never  have 
access  to  the  ledgers,  and  that  a  ledger  clerk  should  have 
no  access  to  the  cash. 

Theoretically  this  is  an  ideal  condition  and  exists  in 
most  large  concerns,  not  because  the  proprietors  realize 
that  it  is  a  proper  safeguard,  but  because  there  is  enough 
of  each  class  of  work  to  warrant  the  employment  of  an 
individual  clerk  for  each  class.  But  in  a  small  business 
where  the  cashier's  duties  are  not  extensive  enough  to 
keep  him  busy  all  the  time,  he  is  required  to  assist  with 
other  duties,  and  naturally  he  is  expected  to  undertake  the 
work  for  which  he  is  best  qualified — the  postings  to  the 
ledgers.  So  long  as  there  are  business  enterprises  the 
proprietors  of  which  consider  that  a  bookkeeper's  duties 


THE    DETAILED    AUDIT 


297 


include  the  functions  of  a  cashier  as  well  as  those  of  a 
ledger  clerk,  it  will  be  necessary  to  exercise  special  vigil- 
ance in  the  audit  thereof,  for  fraud  is  so  easily  concealed 
that  many  clerks  yield  to  temptation,  knowing  that  their 
defalcation  will  not  be  disclosed  unless  a  professional  audi- 
tor is  employed. 

And  in  many  instances  where  professional  auditors 
have  been  expected,  the  clerks  have  used  most  ingenious 
means  to  conceal  their  fraud,  so  that  an  auditor  should 
have  a  knowledge  of  as  many  of  these  subterfuges  as 
possible  in  order  to  detect  irregularities  of  any  nature. 

Prior  Periods 

In  a  detailed  audit  covering,  say,  a  year,  the  question 
frequently  arises  as  to  the  auditor's  responsibility  for  the 
period  prior  to  the  commencement  date.  He  will,  of 
course,  have  it  definitely  understood  that  the  commencing 
date  should  be  definitely  fixed  and  be  supported  by  a  bal- 
ance sheet  which  is  assumed  to  be  correct. 

As  a  matter  of  fact,  there  is  little  danger  in  this  pro- 
cedure. A  proper  audit  for  a  year  must  of  necessity  shed 
a  clear  light  on  the  operations  of  the  period  immediately 
preceding,  and  if  nothing  in  the  current  work  has  given 
rise  to  suspicion,  the  former  accounts  may  be  left  undis- 
turbed. Of  course,  if  any  special  reason  exists,  or  a  client 
insists  on  going  back  for  two  or  more  years,  the  auditor 
must  comply,  but  he  should  make  the  suggestion  that  the 
last  year  should  be  audited  and  reported  upon  first,  so 
that  there  will  be  a  chance  for  reflection  before  incurring 
the  expense  incident  to  a  long  engagement. 

Verification  of  Footings  and  Postings 

The  least  important  part  of  the  audit  is  the  verification 
of  footings  and  postings,  but  the  subject  demands  atten- 


298 


AUDITING 


tion  and  will  then  be  dismissed.  It  will  have  to  be  a  very 
small  business  indeed  where  there  can  be  any  justification 
for  verifying  every  posting  and  every  footing.  In  past 
years  about  half  of  the  auditing  which  was  done  consisted 
of  the  laborious  work  of  checking  postings  in  detail  and 
verifying  the  footings  of  all  books,  including  the  ledgers. 
An  analysis  of  various  defalcations  which  have  occurred  in 
recent  years  demonstrates  the  fact  that  the  percentage 
of  frauds  which  have  been  concealed  by  false  postings  and 
incorrect  footings  is  small.  This  small  percentage  may 
be  covered  just  as  well  in  what  may  be  called  a  "test" 
audit  as  in  a  so-called  detailed  audit.  Where  books  are 
out  of  balance  there  is  a  distinct  value  in  checking  over 
as  many  postings  and  footings  as  possible,  for  it  not  only 
gives  the  auditor  a  chance  to  see  at  first  hand  the  sort  of 
errors  which  the  bookkeepers  have  been  making  and  thus 
furnishes  data  for  his  report,  but  it  helps  along  the  cur- 
rent work,  and  if  all  the  differences  are  located,  he  will 
earn  the  good-will  of  the  bookkeeper,  which  is  also  an 
important  matter.  The  undertaking  of  this  sort  of  work 
is  dangerous,  however,  unless  it  has  been  definitely 
arranged  with  the  client  and  he  is  convinced  that  part  of 
the  work  being  done  is  that  of  an  accountant  and  part 
that  of  an  auditor. 

Some  auditors  are  fond  of  testing  the  ledger  postings 
by  making  up  their  own  controlling  accounts,  or  else 
reversing  the  process  and,  by  analyzing  each  ledger 
account,  extracting  the  totals  of  each  source  of  original 
entry.  There  are  very  exceptional  cases  where  this  plan 
may  be  followed,  principally  where  tKe  ledger  is  not  in 
balance.  It  is  an  old-fashioned  scheme,  however,  and  has 
no  place  under  modern  methods  in  a  well-ordered  plan. 
Great  advantages  accrue  to  the  auditor  who  knows 
enough  to  be  able  to  prove  such  work  by  tests  and  scru- 


THE    DETAILED    AUDIT  299 

tiny  and  thus  gain  valuable  time  which  can  be  devoted  to 
other  and  more  important  work — more  important  because 
the  largest  number  of  frauds  occur  in  other  places  than 
footings  and  postings.  Therefore,  in  that  vast  number  of 
audits  where  there  has  been  no  fraud,  but  where  the 
auditor  wishes  to  justify  his  employment,  all  the  construc- 
tive or  labor-saving  suggestions  w^ill  arise  from  the  other 
portions  of  the  work. 

Many  cases  are  known  of  audits  occupying,  say,  four 
weeks,  where  the  verification  of  footings  and  postings  has 
taken  three  weeks  and  all  the  rest  of  the  audit  has  taken 
one  week.  There  can  be  no  hard-and-fast  rule  as  to  the 
time  each  class  of  work  should  take,  and  it  is  not  worth 
while  to  attempt  to  approximate  one,  but  it  must  be 
obvious  that  unless  there  is  some  specific  justification  for 
this  division,  it  would  be  far  better  to  spend  one  week  on 
postings  and  footings  and  three  weeks  on  work  which 
afterward  wall  mean  something  to  the  clients. 

The  question  arises:  Is  it  not  possible  that  in  thus  cut- 
ting down  the  work  by  two-thirds  too  much  has  been 
taken  for  granted  and  that  an  auditor  would  not  be 
excused  who  neglected  such  a  material  part  of  the  work 
as  that  of  verifying  the  footings  and  postings?  The  latter 
part  of  the  question  is  answered  by  the  statement  that  no 
auditor  can  be  excused  who  neglects  any  part  of  the  work. 
We  must,  however,  be  sure  in  each  case  which  is  presented 
that  we  take  nothing  for  granted  until  we  have  made  such 
intelligent  and  exhaustive  tests  as  will  assure  us  that  the 
accounts  as  a  whole  are,  in  our  judgment,  correct.  Note 
the  expression  '*in  our  judgment";  for  the  moment  you 
deprive  the  auditor  of  the  free  exercise  of  his  judgment, 
you  are  reducing  him  to  the  position  of  an  automaton,  and 
the  title  of  professional  auditor  becomes  a  misnomer. 
What  is  an  intelligent  and  exhaustive  test  of  postings  and 


300 


AUDITING 


footings?  In  seeking  an  answer,  first  direct  your  atten- 
tion to  the  four  general  groups  into  which  they  can  be 
divided.  These  are:  (1)  the  records  of  the  purchase  of 
goods  or  materials  as  reflected  in  purchase  or  invoice 
books,  voucher  registers,  etc.;  (2)  the  records  of  sales  as 
found  in  sales  books  or  binders  or  in  any  one  of  the  various 
good  and  bad  forms  used;  (3)  the  receipt  of  cash;  (4)  the 
payment  of  cash. 

The  majority  of  postings  and  footings  occur  with 
respect  to  the  records  mentioned,  so  that  if  we  can  agree 
on  what  constitutes  a  fair  test  of  these  groups  or  divisions, 
we  can  safely  leave  the  remaining  records  to  be  dealt  vdth 
on  their  merits. 

The  following  suggestions  are  grounded  upon  the 
fundamental  principle  that  no  audit  is  complete  unless 
the  trial  balances  of  all  the  ledgers  have  been  proved. 
There  may  be  exceptions,  as,  for  instance,  a  department 
store  where  there  are  one  hundred  individual  ledgers,  in 
which  case  an  exhaustive  test  would  be  sufficient., 

I.  Purchase  Records 

If  fraud  exists  with  respect  to  purchases,  it  usually 
will  be  found  in  overcharges  or  fictitious  vendors,  arid 
very  seldom,  if  ever,  will  there  be  any  concealment  of  fraud 
through  manipulations  of  footings  or  postings.  The  audi- 
tor does  not  seek  to  locate  clerical  errors  in  trial  balances, 
but  is  concerned  with  the  possibility  of  the  trial  balance, 
which  is  ostensibly  in  agreement,  being  forced.  As  this 
occurs  not  only  in  cases  where  fraud  exists,  but  also  where 
there  is  a  lazy  or  incompetent  bookkeeper,  the  auditor 
should  always  be  on  the  lookout  for  evidence  of  forced 
balances.  As  a  rule,  however,  where  a  trial  balance  is 
forced  there  will  be  no  alteration  in  the  current  postings 
and  footings.    The  usual  and  popular  expedient  is  to  alter 


THE    DETAILED    AUDIT  301 

in  the  ledger  the  last  posting  during  the  period  to  one  of 
the  large  nominal  accounts,  such  as  sales  or  expenses. 

These  remarks  as  to  the  trial  balance  have  a  bearing 
on  purchase  records  to  the  extent  that,  no  matter  what 
other  detail  work  is  omitted,  the  verification  of  the  post- 
ings of  the  monthly  or  periodical  aggregates  must  not  be 
forgotten.  By  this  is  meant  the  debit  side  of  the  purchase 
accounts.  Usually  the  checking  of  the  credit  postings  can 
be  omitted. 

As  to  the  footings,  in  a  fairly  large  concern,  prove  the 
footings  of  about  every  tenth  or  twelfth  page  in  addition 
to  the  last  page  of  each  month,  where  the  audit  covers  a 
period  of  one  year.  In  a  smaller  concern,  prove,  say,  every 
fifth  or  sixth  page,  including  always  the  last  page  of  each 
month.  It  is  hard  to  imagine,  and  wide  experience  has 
not  developed,  a  case  where  such  a  percentage  would  not 
have  been  just  as  effective  in  any  given  audit  as  the  verifi- 
cation of  the  footing  of  every  page.'  That  is,  the  verifica- 
tion of  every  page  did  not  disclose  any  discrepancies 
(except  as  hereafter  noted),  so  that,  naturally,  the  work 
could  have  been  cut  down  eleven-twelfths  with  equal 
results  (except  as  to  cost  to  the  client).  The  last  page  in 
every  case  is  mentioned  particularly,  because  instances  are 
known  where  such  figures  have  been  altered. 

2.  Sales  Records 

The  monthly  or  other  aggregates  of  the  sales  postings 
should  be  checked. 

Controlling  Account 

If  there  is  a  controlling  account  in  the  general  ledger 
with  customers,  it.  will  not  be  necessary  to  verify  in  detail 
the  postings  of  the  customers  ledgers.  If  there  is  no 
controlling  account,  the  auditor  should  construct  one,  so 


302  AUDITING 

in  neither  case  is  it  worth  while  to  prove  the  debit  post- 
ings. 

The  controlling  account  is  a  compilation  of  the  aggre- 
gates of  the  postings  to  the  individual  customers'  accounts. 
They  may  be  classified  as  follows : 


Debits 

Credits 

Total  of  opening  balances,  as  per 

Cash 

last  trial  balance 

Sales 

Discounts 

Protested    or    returned    cheques, 

Returns  and  Allowances 

notes,  etc. 

Interest,  etc 

Notes 

Accounts  charged  off,  etc. 

Total  of  closing  balances 

In  some  sets  of  books  it  may  take  as  much  work  to 
construct  the  controlling  account  as  to  verify  every  post- 
ing; but  even  so,  the  time  spent  in  the  preparation  of  the 
account  is  not  lost,  because  the  data  secured  thereby  will 
be  useful  in  stating  the  results  of  the  business. 

There  is  more  fraud  in  connection  with  accounts 
receivable  than  in  any  other  department  of  a  business, 
but  the  fraud  does  not  consist  in  a  failure  to  post  the 
sales  which  are  recorded  in  the  sales  books  to  the  ledgers. 
The  fraud  here  is  in  omitting  the  sales  from  the  sales 
records  entirely  or  in  the  failure  to  enter  cash  collec- 
tions. 

It  is,  however,  important  to  know  that  all  the  sales 
appearing  in  the  sales  record  have  been  posted.  As  stated 
above,  this  can  be,  and  should  be,  covered  by  use  of  a 
controlHng  account,  as  the  items  are  of  such  a  nature 
that  they  are  grouped  in  the  original  records,  and  where 
the  posting  of  a  thousand  entries  in  one  can  be  proved 
by  one  operation,  time  is  saved.  This  method  assumes, 
of  course,  that  there  will  be  a  verified  trial  balance  of  the 


THE    DETAILED    AUDIT 


303 


customers  ledgers  to  support  the  controlling  account. 
The  question  of  accounts  which  have  been  collected, 
but  which  do  not  show  the  collections,  will  be  considered 
later. 

As  to  the  footings,  verification  is  somewhat  more  im- 
portant than  with  purchase  records.  In  a  large  concern, 
prove,  say,  every  eighth  page,  and  in  a  small  concern, 
say,  every  third  or  fourth  page,  always  including  the  last 
and  sometimes  the  next  to  last  page  of  each  month. 

Cheques  Received  Must  be  Deposited 

In  those  corporations  where  the  capital  stock  is  all, 
or  nearly  all,  owned  by  its  officers  or  directors,  the  latter 
frequently  handle  the  funds  of  the  corporation  as  if  no 
corporate  responsibility  existed.  Usually  they  act  hon- 
estly and  no  harm  is  done,  but  an  auditor  cannot  afford  to 
pass  over  illegal  acts  which  come  to  his  knowledge, 
although  so  far  as  can  be  foreseen  no  one  will  be  injured 
thereby. 

The  practice  of  an  ofificer  using  cheques  drawn  to  the 
order  of  the  corporation  for  his  private  use  cannot  be 
condemned  too  severely,  and  yet  it  is  not  uncommon. 
All  cheques  should  be  deposited,  and  the  of^cer  can 
withdraw  a  similar  sum  if  the  corporation  is  indebted 
to  him. 

In  a  New  York  case,  decided  by  the  Court  of  Appeals 
in  1908,  where  the  president  of  a  corporation  (the  stock 
of  which  was  all  owned  by  himself  and  the  secretary- 
treasurer)  used  a  cheque  drawn  to  the  order  of  the  corpo- 
ration and  indorsed  by  it  to  pay  his  personal  debt,  the 
creditors  of  the  corporation  upon  its  being  declared  insol- 
vent compelled  the  trust  company  that  cashed  the  cheque 
to  refund  the  money.  (N.  Y.  Court  of  Appeals  Reports 
192,  p.  61.) 


304  AUDITING 

Periodical  Verification  of  Bank  Balances 

The  auditor  should  ascertain  by  personal  investigation 
whether  the  bank  balances  have  been  verified  at  frequent 
intervals  throughout  the  period  covered  by  the  audit.  It 
frequently  happens  that  clerks  are  careless  about  reconcil- 
ing the  bank  balances  with  those  shown  by  the  books.  In 
some  cases  the  pass-books  are  not  left  for  settlement  for 
many  months;  in  other  cases  the  pass-books  are  balanced 
by  the  banks  and  delivered  to  the  depositors,  but  are  not 
verified  by  the  latter. 

In  the  middle  and  far  West,  the  banks  have  quite 
generally  adopted  the  plan  of  sending  monthly  statements 
to  all  depositors,  accompanied  by  the  paid  cheques.  There 
is  a  growing  tendency  on  the  part  of  the  banks  in  the 
East  to  follow  this  plan.  This  is  to  be  commended,  as 
it  leads  naturally  to  more  frequent  reconciliations  between 
the  parties. 

But  the  bank  statements  may  be  filed  away  without 
examination  unless  some  one  in  authority  insists  on 
prompt  attention.  Instances  have  been  known  where 
junior  clerks  have  forged  signatures  to  cheques,  and  owing 
to  carelessness  in  inspecting  the  bank  settlements,  the 
fraud  was  not  discovered  for  a  long  time. 

The  law  is  that  the  writing  up  of  a  bank  pass-book, 
with  a  return  of  paid  cheques,  or  a  statement  of  account, 
is  not  conclusive  upon  the  parties  so  as  to  preclude  an 
ascertainment  of  the  true  state  of  the  accounts  in  a  case 
where  cheques  are  included  in  the  balance  which  are  sub- 
sequently discovered  to  be  forged.  But  where  the 
depositor  is  under  a  duty  from  the  usages  of  business  or 
otherwise  to  examine  the  account  within  a  reasonable 
time  and  to  give  timely  notice  of  any  objections  he  may 
have,  an  omission  to  perform  this  duty,  leaving  the  bank 
to  rely  upon   the  presumption   that   the  account   is  ac- 


THE    DETAILED    AUDIT 


305 


quiesced  in,  whereby  it  is  misled  to  its  prejudice,  will  make 
the  account  conclusive.  The  law  is  not  unreasonable  in 
holding  that  where  bank  settlements  lie  around  un- 
touched for  long  periods  those  in  control  of  the  business 
should  know  that  a  risk  is  being  run  for  which  there  is 
no  excuse. 

The  auditor  may  sympathize  with  the  clerk  who  is 
overworked  and  who  omits  the  reconciliation  of  the  bank 
balances  for  what  he  considers  more  important  duties,  but 
nevertheless,  such  neglect  may  be  costly  and  should  be 
reported. 

In  a  stock-broker's  ofifice  the  cashier  drew  cheques  to 
the  order  of  bearer,  had  them  signed  by  a  partner, 
diverted  the  proceeds  to  his  own  use,  and  destroyed  the 
cheques  when  returned  by  the  banks.  The  stubs  of  these 
cheques  were  marked  ''canceled."  In  order  that  the 
reconcilement  of  the  bank  pass-book  with  the  cheque 
book  might  appear  to  be  in  order,  he  understated  the 
footings  of  outstanding  cheques  by  amounts  equal  to  the 
shortage.  Here  the  auditor  would  have  discovered  the 
fraud  by  personally  balancing  the  bank  account  and  secur- 
ing direct  confirmation  of  the  bank  balance.  He  also 
would  have  been  put  on  notice  by  the  absence  of  the 
cheques  marked  "canceled." 

Unless  there  is  some  special  reason  for  so  doing,  the 
auditor  need  not  verify  the  detailed  statement  or  pass- 
book wherein  are  Hsted  in  detail  the  cheques  paid  by  the 
bank.  Particularly  is  this  so  where  the  auditor  is  able  to 
secure  the  last  settlement  direct  from  the  bank,  or  before 
anyone  else  has  had  access  to  it.  In  those  cases  where 
fraud  exists  and  the  signatures  to  cheques  have  been 
forged,  or  where  cheques  have  been  properly  signed  but 
the  purposes  are  dishonest,  the  inspection  of  the  list  of 
cheques  paid  by  the  bank  would  disclose  that  certain 


3o6  AUDITING 

items  were  not  entered  on  the  regular  stubs,  and  further 
investigation  would  lead  to  the  discovery  of  the  fraudu- 
lent practice. 

It  is  evident,  however,  that  where  the  auditor  has 
direct  confirmation  of  the  closing  balance  and  makes  the 
verification  of  deposits  and  cheques  referred  to  elsewhere 
herein,  he  will  discover  the  fraud. 

3.  Cash  Receipts 

In  all  well-regulated  concerns  all  cash  receipts  are 
deposited  in  bank  and  all  payments,  therefore,  must  be 
made  from  the  bank  account.  This  almost  disposes  of  the 
question  of  verifying  the  footings  of  the  cash  book. 
Where  the  bank  account  is  proved  and  the  cash  receipts 
and  payments  are  traced  into  and  out  of  bank,  it  would 
seem  logical  that  the  footings  of  the  cash  book  could  be 
automatically  proved  at  the  same  time.  If  this  does  not 
seem  to  be  complete  verification,  in  a  large  business,  the 
proving  of  every  third  or  fourth  page  will  be  a  complete 
check. 

In  every  case,  however,  where  there  is  any  possibility 
of  the  receipt  of  any  considerable  amount  of  currency 
from  sales  over  the  counter,  and  where  such  receipts  are 
not  deposited  daily  in  gross,  there  will  be  opportunities 
for  manipulation  not  possible  under  other  circumstances. 
Consequently  the  auditor  must  be  specially  vigilant  in 
looking  for  fraud. 

In  the  case  cited  on  page  339  the  cashier  failed  to 
deposit  a  portion  of  the  receipts  from  cash  sales  from 
time  to  time,  although  the  correct  amounts  thereof  were 
entered  in  the  cash  book  daily.  About  once  a  year  he 
concealed  the  amount  embezzled  by  overstating  payments 
for  merchandise  purchases.  In  an  annual  audit,  made 
after  the  close  of  the  year,  it  would  be  difficult  to  detect 


THE    DETAILED    AUDIT 


307 


such  fraud  except  by  comparing  every  cheque  issued 
during  the  year  with  the  cash  book,  or  by  examining  every 
voucher,  because  it  is  not  usual  to  attempt  to  verify  the 
cash  book  balances  at  any  date  other  than  the  closing 
date.  Of  course,  if  that  had  been  done  here  it  would 
have  shown  that  the  cash  book  balance  was  com- 
posed of  a  certain  sum  in  bank  and  a  very  large  amount 
"on  hand."  The  size  of  the  latter  would  have  excited 
suspicion,  but  legal  proof  could  hardly  be  found  to 
sustain  a  claim  that  it  was  not  in  the  cash  drawer  at 
the  time. 

In  many  small  concerns  the  cashier  handles  the 
receipts,  writes  up  the  cash  book,  and  makes  the  deposits. 
He  might  retain  a  portion  of  the  receipts,  force  the 
footings  of  the  column  to  agree  with  the  actual  deposit, 
and  increase  the  footings  of  the  discount  column.  The 
cash  book  would  then  balance  across,  the  cash  balance 
agree  with  the  amount  shown  by  the  pass-book,  and  as 
the  discount  column  would  be  posted  in  total  by  the 
bookkeeper,  the  ledger  would  be  in  balance  without  any 
falsification  being  made  therein.  If  there  were  special 
columns  provided  for  cash  sales  or  similar  earnings,  the 
footings  of  such  columns  could  be  reduced  by  the  amount 
of  the  shortage  and  thus  afiford  additional  facilities  for 
covering  up  the  amounts  taken.  Where  this  possibility 
exists,  the  footings  of  the  discount  and  similar  columns 
should  be  verified. 

The  postings  of  the  nominal  accounts  should  usually 
be  verified,  not  because  there  is  any  great  danger  of  fraud 
lurking  therein,  but  for  the  purpose  of  locating  any 
possible  posting  to  a  wrong  account.  For  instance,  it 
frequently  happens  that  part  of  a  plant  or  old  machinery 
may  be  sold.  Sometimes  such  items  are  posted  to  an 
earning   account   instead   of   to   a   capital   or  a    reserve 


3o8 


AUDITING 


account.  These  postings  are,  as  a  rule,  few  in  number 
and  are  important  enough  to  be  verified  in  extenso. 

The  postings  to  the  credit  of  customers  should  be 
proved  in  totals  through  the  controlling  accounts.  If 
there  is  no  controlling  account  and  one  cannot  be  con- 
structed readily,  a  fair  test  should  be  made  of  the  individ- 
ual ledger  credits,  working,  of  course,  from  the  ledger 
back  to  the  cash  book  and  not  vice  versa.  The  reason 
for  this  is  obvious;  if  a  customer  has  been  credited  with 
an  amount  which  purports  to  have  been  posted  from  the 
cash  book,  but  which,  as  a  matter  of  fact,  is  not  entered 
there  at  all,  the  discrepancy  would  not  be  discovered  by 
using  the  cash  book  as  a  basis,  and  it  would  not  be  safe 
to  depend  on  looking  through  the  ledger  subsequently  to 
see  that  all  items  are  ticked.  It  is  sometimes  suggested 
that  the  chief  danger  in  such  practice  Hes  in  the  possibility 
that  the  ledger  clerk  can,  where  the  work  is  not  finished 
at  a  sitting,  supply  the  ledger  tick  marks  himself.  There 
is  not  much  basis  for  this  fear,  but  it  would  be  fooHsh  to 
expose  one's  self  to  it  where  no  necessity  exists. 

If  it  is  thought  wise  to  verify  the  individual  postings 
to  the  customers'  accounts,  do  not  check  every  one  unless 
some  very  good  ground  for  suspicion  exists.  If  the  audit 
is  a  periodical  one,  say,  for  six  months,  cover  about  half 
the  letters  of  the  alphabet  only.  Six  months  later  cover 
the  other  half,  or  one-fourth  only  at  each  audit,  and  take 
two  years  to  the  entire  list.  It  is  not  an  infrequent  fraud 
wherein  ledger  credits  do  not  appear  as  cash  debits,  but 
it  is  hard  to  imagine  one  case  where  a  good  test  would  not 
have  disclosed  the  fraud.  Very  few  men  would  confine 
their  peculations  to  customers  whose  names  commenced 
with  X  Y  Z  only.  The  auditor  can  afford  to  take  the 
chance  that  the  defaulter  will  inadvertently  manipulate 
the  account  of  an  A  customer,  in  which  case  he  would  not 


THE    DETAILED    AUDIT  309 

escape  the  first   time,  and  if  he  used  only  one  or  two 
letters,  he  would  still  be  detected  in  a  reasonable  time. 

4.  Cash  Payments 

On  the  payment  side  there  is  also  a  possible  oppor- 
tunity for  fraud  being  covered  by  erroneous  footings.  In 
most  cash  books  there  are  columns  for  different  expenses 
which  are  posted  in  total  at  the  end  of  the  month.  If  the 
cashier  were  to  take  an  unnumbered  cheque  from  the  back 
of  the  book,  or  one  of  a  style  similar  to  the  ones  in  current 
use,  and  have  it  drawn  to  his  order  or  to  some  name  repre- 
senting himself  and  did  not  enter  the  amount  in  the  cash 
book,  the  footings  could  be  falsified  to  that  extent.  The 
cheque  could  be  numbered  to  correspond  with  those  in 
use  at  the  time.  When  the  bank  settlement  was  received 
and  the  balance  verified,  the  cheque  could  be  destroyed. 

Every  cheque  forming  part  of  a  series,  or  bearing  any 
distinguishing  mark  connecting  it  with  the  concern  under 
audit,  should  be  accounted  for.  If  spoiled,  the  half  con- 
taining the  serial  number  or  other  identifying  mark  should 
be  preserved  and  pasted  on  the  stub.  Cheques  should 
never  be  removed  from  the  back  of  a  book,  but  if  they 
are,  for  some  special  reason,  they  should  be  accounted  for. 

Frequently  these  precautions  are  not  enforced,  due  to 
ignorance  or  carelessness.  In  such  cases  the  auditor 
should  report  thereon  and  suggest  an  immediate  change 
relative  thereto.  If  in  subsequent  audits  no  improvement 
is  found,  more  severe  criticism  will  be  in  order. 

It  is  not  easy  to  secure  blank  cheques  bearing  the 
name  of  a  concern.  For  this  reason  hundreds  of  cases  of 
fraud  have  existed  through  the  improper  use  of  cheques 
taken  from  the  backs  of  books  or  from  the  front  in  their 
regular  order,  the  stub  indicating  that  the  cheque  was 
spoiled  and  destroyed. 


-lO  AUDITING 

Instances  are  known  where  cheques  were  marked  as 
void  on  the  stubs  and  the  two  halves  of  one  cheque  pasted 
on  two  stubs  (one  of  the  portions,  of  course,  l)eing  with- 
out a  number),  thus  providing  a  cheque  which  was  used 
by  the  cashier  to  obtain  money  fraudulently. 

These  manipulations  are  not  likely  to  occur  more 
than  once  in  an  auditor's  experience,  but  all  of  the  possi- 
bilities mentioned  are  based  on  actual  experience,  so  that 
an  auditor  cannot  afford  to  neglect  all  reasonable  precau- 
tions to  ascertain  if  such  fraud  exists. 

The  auditor  should  insist,  wherever  feasible,  on  hav- 
ing all  payments  represented  by  cheques.  It  reduces  the 
possibility  of  manipulation  of  cash  book  footings  to  a 
minimum,  and  for  this  reason  alone  is  worth  all  the  trouble 
which  may  be  occasioned  by  the  necessity  of  depositing 
all  currency  receipts.  If  the  footings  cannot  be  proved 
by  the  bank  account,  verify,  say,  every  third  or  fourth 
page. 

If  the  cash  book  is  properly  columned  and  a  controlling 
account  is  kept  with  accounts  payable,  most  of  the  post- 
ings will  consist  of  monthly  aggregates,  which  should  be 
checked  to  see  that  they  do  not  get  into  the  wrong  ledger 
account.  Here,  however,  it  is  important  to  avoid  dupli- 
cation. In  many  audits  it  is  desirable  to  make  full  analyses 
of  the  various  expense  and  purchase  accounts  for  use  in 
the  reports.  If  feasible  and  convenient  this  work  should 
be  done  at  the  time  of  the  verification  of  the  postings, 
for  it  may  be  found  that  the  details  in  the  ledger  are  not 
sufficient  and  the  cash  book  pages  must  be  consulted  again. 

Postings  to  the  individual  accounts  need  not  be  veri- 
fied unless  some  special  reason  appears.  The  payments 
are  supposed  to  be  vouched  to  establish  their  authenticity, 
and  it  is  not  necessary  to  trace  the  payments  to  the  debits 
of  the  accounts.     A  controlling  account  supported  by  a 


THE    DETAILED    AUDIT  311 

trial  balance  of  the  subsidiary  ledger  is  a  good  proof,  but 
even  where  this  is  not  in  evidence  the  checking  of  the 
debit  postings  is  usually  superfluous. 

Summary 

As  against  the  practice — fairly  common — of  checking 
all  postings  and  footings,  the  above  course  will  seem 
radical.  It  is  not  radical,  however,  if  it  is  approved  after 
full  discussion  and  thought,  and  if  it  will  stand  the  addi- 
tional test  of  each  particular  audit.  Where  the  slightest 
cause  for  suspicion  exists,  there  must  be  a  careful  study 
of  every  phase  of  the  situation. 

But  if  suspicion  has  been  aroused  and  there  is  a  prob- 
ability of  something  being  wrong,  the  most  foolish  thing 
an  auditor  can  do  is  to  jump  in  blindly  and  tick  every 
entry  in  the  books.  This  has  been  done  more  than  once, 
but  the  practice  cannot  be  condemned  too  strongly. 

Other  Records 

In  many  lines  of  business  the  books  of  account  bear 
distinctive  titles,  and  it  may  be  that  in  the  foregoing  pages 
these  books  have  not  been  called  by  their  technical  names. 
For  instance,  in  a  magazine  publishing  business  a  sales 
book,  so  called,  may  not  be  found,  but  a  subscription 
record  and  an  advertising  register  will  usually  be  kept. 

With  these  books,  as  to  footings  and  postings,  about 
the  same  procedure  should  be  followed  as  with  a  regula- 
tion sales  book — as  a  matter  of  fact,  that  is  exactly  what 
these  two  records  represent — sales  of  advertising  space 
and  sales  of  copies  of  the  publication  for  a  stated  period 
(subscriptions).  It  is  far  more  satisfactory  to  have  an 
illuminating  title  like  this  for  a  book  than  to  attempt  to 
cut  down  the  number  of  account  books  in  use  and  per- 
haps journalize  every  transaction.    Aside  from  the  saving 


312  AUDITING 

of  labor  to  a  bookkeeper  through  the  use  of  books  for 
special  purposes,  is  the  more  important  function  of  keep- 
ing the  records  clear  to  one  who  does  not  understand 
bookkeeping.  Most  business  men  are  at  sea  when  they 
try  to  understand  an  ordinary  journal,  but  if  a  book  is 
labeled  ''subscription  record,"  or  ''advertising  register," 
anyone  with  ordinary  intelligence  knows  exactly  what  to 
look  for  within  its  pages. 


CHAPTER    XV 

THE  DETAILED  AUDIT  (Continued) 


VERIFICATION  OF  INCOME 

It  is  obvious  that  a  dependable  analysis  of  frauds  can 
never  be  compiled  from  accurate  data,  but  an  estimate 
prepared  from  long  experience  supports  the  assertion  that 
nearly,  if  not  quite,  75  per  cent  of  defalcations  and  frauds 
are  connected  directly  with  a  failure  to  account  for  income 
or  cash  receipts,  and  less  than  25  per  cent  with  methods 
of  improperly  diverting  cash  after  it  has  found  its  way 
into  the  treasury. 

We  will  discuss  as  of  the  more  importance  the  75  per 
cent  division.  This,  in  turn,  can  be  divided  into  two 
groups:  the  first  embracing  that  class  of  frauds  which 
consists  in  a  failure  to  enter  in  the  books,  or  at  least  in 
the  books  which  form  a  part  of  the  double-entry  system, 
any  record  whatever  of  the  sale  or  delivery  of  goods  or 
materials;  the  second  class  includes  those  cases  where 
there  is  a  record  of  the  original  sale  or  delivery,  but  where 
the  subsequent  collection  is  omitted  entirely  or  where  the 
entry  of  collection  is  postponed  until  a  later  date.  Obvi- 
ously, the  former  methods  will  be  the  ones  most  easily 
concealed,  and  the  auditor  must,  therefore,  be  especially 
vigilant  in  this  part  of  the  audit. 

It  is  assumed  that  the  auditor  has  secured  a  list  of  all 
books  in  use.  This  list  should  include  not  only  the  books 
which  form  part  of  the  double-entry  system,  but  also  all 

313 


314 


AUDITING 


those  usually  termed  ^'memorandum"  books,  which  con- 
tain original  data,  and  from  which  the  formal  entries  are 
compiled. 

When  the  audit  is  completed  the  auditor  should  be 
able  to  certify  that,  in  his  opinion,  all  revenue  or  earnings 
have  been  properly  accounted  for.  This  does  not  mean 
that  the  cash  which  was  duly  entered  in  the  cash  book  and 
the  sales  which  were  in  due  course  entered  in  the  sales 
records  were  assumed  to  be  all  the  cash  receipts  and  all 
the  sales  without  further  investigation. 

A  careful  inquiry  should  be  made,  or  personal  watch 
kept,  to  see  who  opens  the  mail,  and  what  record,  if  any, 
is  made  by  such  person.  The  record,  if  a  ^'memorandum" 
one,  should  be  compared  (in  part)  with  the  formal  books. 

Sales 

It  is  important  to  ascertain  that  all  cash  sales  are 
accounted  for.  In  nearly  every  business  some  sales  are 
collected  for  at  once  and  are  not  passed  through  the  cus- 
tomers ledgers.  If  the  general  ledger  shows  few  such 
transactions,  this  should  not  influence  the  auditor  unless 
he  has  made  inquiry  from  some  one  other  than  the  cashier. 
One  instance  may  be  cited  where  the  auditor  found  that 
there  were  practically  no  cash  sales  accounted  for.  He 
inquired)  as  to  this  and  was  informed  that  it  was  not  the 
custom  to  make  such  sales.  Further  investigation,  how- 
ever, developed  the  fact  that  the  cash  sales  had  been 
quite  large,  but  that  his  first  informant  had  pocketed  the 
whole  proceeds.  In  this  case  a  rough  memorandum  was 
discovered  which  enabled  the  auditor  to  locate  the  entire 
shortage.  It  will  be  found  the  rule  rather  than  the  excep- 
tion that  there  is  some  sort  of  record  which  can  be  com- 
pared with  the  cash  book.  The  formal  original  records, 
which  are  nicely  written  up  and  which  agree  exactly  with 


THE    DETAILED    AUDIT 


3^5 


the  other  books,  are  not  the  ones  the  auditor  wants. 
If  he  can  find  the  first  "originals,"  in  rough  form,  perhaps, 
and  very  dirty  and  almost  illegible,  there  is  no  doubt 
about  the  advisability  of  using  such  records  in  preference 
to  the  fair  copies,  because  the  latter  are  frequently  written 
up  by  the  same  men  who  write  up  the  final  cash  records. 
Professional  auditors  agree  that  original  records  corre- 
sponding closely  to  the  above  description  have  revealed 
to  them  perhaps  more  instances  of  fraud  than  any  other 
source.  The  importance  placed  upon  them  cannot,  there- 
fore, be  overestimated. 

The  list  of  memorandum  books  required  should  include 
the  original  records  of  sales  and  the  original  records  of 
shipments.  Rarely  are  the  order  books  or  shipment  or 
delivery  books  considered  as  formal  books  of  account, 
and  it  is  perhaps  fortunate  for  the  auditor  that  this  is  so, 
because  in  many  cases  where  the  examination  of  these 
records  has  revealed  fraud  there  has  been  great  astonish- 
ment and  usually  indignation  that  an  auditor  should  ask 
to  see  "memorandum"  books.  In  most  of  these  cases  if 
the  defaulters  had  suspected  that  the  books  mentioned 
would  be  called  for,  they  could  readily  have  been  destroyed 
or  altered  before  examination. 

It  is  the  auditor's  duty  to  verify  the  income  from  sales 
as  evidenced  by  the  records  or  papers  covering. the  trans- 
actions from  the  time  an  order  is  received  until  the  goods 
have  been  delivered.  Wherever  possible,  therefore,  he 
secures  the  order  books  and  compares  some  of  them  with 
the  ledgers  to  see  that  the  orders  were  filled.  If  not,  why 
not?  It  may  be  that  through  carelessness  an  order  was 
not  filled  and  that  it  was  not  reported.  Here  is  a  good 
chance  to  be  of  positive  value  to  the  client. 

Orders  may  have  been  filled  and  the  proceeds  collected 
and  not  accounted  for.     This  should  be  discovered  by 


3i6 


AUDITING 


comparing  the  shipping  or  delivery  books  with  the  sales 
records.  Tests  here  are  all  that  are  necessary,  because 
any  system  of  fraud  in  this  channel  has  been,  in  practically 
all  known  cases,  continuous,  so  that  a  complete  compari- 
son for  a  few  weeks  or  a  month  would  cover  the  point 
quite  as  well  as  a  more  exhaustive  comparison. 

A  fruitful  source  of  inspiration  in  the  effort  to  ascer- 
tain whether  or  not  all  the  income  has  been  accounted 
for  is  the  balance  sheet — or  the  trial  balance  after  closing, 
which  may  state  the  various  items  of  assets  in  greater 
detail  than  the  balance  sheet.  Proper  thought  should 
be  devoted  to  each  item  to  determine  the  possibility  of 
the  income  therefrom  being  omitted  from  the  books.  For 
instance,  a  mining  company's  balance  sheet  may  show 
that  it  owns  workmen's  houses.  The  auditor  will  then 
have  to  find  out  if  all  of  the  rents  of  all  the  houses  have 
been  accounted  for.  Furthermore,  where  there  are  ten- 
ants he  will  usually  find  sales  to  them  of  coal  or  other 
fuel  and  all  sorts  of  supplies.  If  he  does  not  find  any 
record  of  such  sales,  he  should  inquire  why  from  some  one 
"higher  up."    He  should  not  take  the  cashier's  word  for  it. 

These  comments  are  merely  suggestive  and  serve  to 
illustrate  the  idea  that  the  auditor  must  not  use  the  receipt 
side  of  the  cash  book  as  a  basis  for  verifying  the  actual 
income  or  receipts.  He  must  work  from  every  outside 
source  he  can  find  to  the  cash  book,  and  he  will  then  be 
reasonably  safe. 

There  is  not  the  same  difficulty  with  the  cases  in  which 
there  has  been  some  record  in  one  of  the  original  books 
of  account  of  a  sale,  the  subsequent  collection  of  the  pro- 
ceeds of  which  has  not  been  accounted  for,  or  in  which 
although  the  sales  have  been  debited  in  due  course  to 
customers,  the  collections  have  not  been  credited. 

The  former  class  will  be  disclosed  by  a  good  test  of 


THE    DETAILED    AUDIT 


31: 


the  footings  of  the  sales  records,  and  the  proof  of  the  post- 
ings of  same  to  the  customers  ledgers.  This  has  been 
fully  covered.  The  instances  where  credits  have  been 
arbitrarily  made  to  customers'  accounts,  but  without  cor- 
responding entry  in  the  cash  book,  have  also  been  covered. 

Cash  Discounts 

The  auditor  should  secure  from  the  principals  an 
authoritative  statement  of  cash  discounts  allowed  to  cus- 
tomers, and  with  this  as  a  basis  a  fairly  exhaustive  test 
should  be  made  of  the  discount  deductions  or  allowances 
as  stated  in  the  cash  book.  In  rare  cases  the  cash  book 
will  show  net  receipts  only,  in  which  event  discounts  are 
credited  through  an  allowance  book  or  journal,  but  as  the 
latter  method  involves  writing  customers'  names  twice, 
no  up-to-date  concern  would  permit  it.  The  discounts 
should  appear  in  a  column  on  the  receipt  side  of  the  cash 
book,  and  next  to  the  column  containing  the  gross  or  net 
collections  from  customers. 

For  convenience  in  posting,  the  gross  amount  is  some- 
times entered  in  the  "Accounts  Receivable"  column.  The 
total  of  the  discount  column  must  then  be  deducted  there- 
from in  order  to  arrive  at  the  cash  balance.  The  better 
practice,  however,  is  to  enter  the  net  cash  collection  in  one 
column  and  the  amount  of  the  discount  in  the  next.  In 
posting,  the  two  amounts  should  be  entered  "in  short"  on 
the  credit  side  of  the  customer's  account-  and  the  gross 
amount  extended  to  the  money  column. 

Instances  are  known  where  cashiers  have  systemati- 
cally overstated  the  discount  allowance  either  by  increas- 
ing the  amount  actually  deducted  or  by  entering  a  dis- 
count where  none  was  claimed  or  allowed.  This  is  a  mat- 
ter to  which  little  attention  is  directed  in  an  establishment 
where  the  work  of  cashier  and  bookkeeper  is  performed 


3i8 


AUDITING 


by  the  same  person,  or  where  the  posting  clerks  are  mere 
machines,  and  can  be  depended  upon  to  overlook  fraud 
of  this  nature.  In  view  of  this  probable  freedom  from 
detection  and  the  numerous  frauds  which  have  thus 
occurred,  the  auditor  must  make  a  test  thorough  enough 
to  satisfy  himself  fully.  It  is  not  likely  that  if  there  is 
anything  wrong  it  will  appear  only  occasionally,  so  that 
the  test,  while  exhaustive  as  to  the  period  covered,  need 
extend  over  only  a  few  days  or  weeks,  depending  on  the 
volume  of  collections. 

Collections  Not  Accounted  for 

We  now  come  to  what  is  believed  to  be  the  most  pro- 
lific source  of  fraud  practiced,  viz.,  the  failure  to  enter  in 
any  book  the  collections  from  customers.  The  detection 
of  such  fraud  is  difificult  and  it  will  pay,  therefore,  to 
devote  considerable  time  and  space  to  the  subject. 

The  most  common  irregularity  can  be  illustrated  as 
follows :  Customer  A  on  January  2  pays  $112.53,  say, 
by  cheque;  the  cashier  fails  to  enter  the  collection  in  his 
books.  If  he  has  made  other  collections  in  currency 
exceeding  $112.53,  he  will  deposit  the  cheque  and  take 
the  equivalent  in  currency  from  the  drawer,  thus  obviating 
the  necessity  of  forging  the  indorsement  and  having  the 
cheque  cashed,  although  the  latter  method  is  more  com- 
mon than  is  generally  supposed.  In  the  first  case  the 
fraud  might  be  discovered  by  comparing  the  details  of 
the  cash  receipts  with  the  details  of  the  bank  deposits  as 
listed  in  the  cheque  stubs  or  copy  books,  but  this  record 
is  not  always  available  and  auditors  frequently  find  that 
where  such  a  fraudulent  practice  exists  the  record  of  the 
bank  deposit  has  been  altered  or  made  up  to  correspond 
with  the  cash  book,  w^hich  makes  the  comparison  of  no 
value. 


THE    DETAILED    AUDIT 


319 


In  most  such  cases  the  thief  does  not  consider  it  safe 
to  hold  out  collections  too  long  for  fear  some  one  in  the 
office  will  discover  that  customer  A  has  not  paid  and  go 
after  him.  Therefore,  on  January  31  he  decides  that  it 
will  not  be  wise  to  hold  up  A's  credit  any  longer,  and 
accordingly  credits  him  with  $112.53  in  the  cash  book, 
and  the  amount  finds  its  way  to  the  ledger  in  due  course. 
By  this  time  the  cashier  is  further  in  trouble:  the  cus- 
tomer B  having  on  January  31  paid  $250  (also  by  cheque) 
the  cashier  fails  to  enter  the  amount  and  thus  creates  a 
cash  ''over"  of  $137.47,  which  he  removes  from  the  cash 
drawer  as  soon  as  he  can  accumulate  that  amount  of  cur- 
rency. Here  again  may  be  urged  the  importance  of  rec- 
ommending, to  clients  the  daily  deposit  of  all  receipts — 
currency  and  cheques.  There  will  then  be  far  less  oppor- 
tunity for  fraud  afforded  to  a  clerk  dishonestly  inclined. 

So  it  continues.  The  defaulter  must  soon  credit  B 
with  $250,  and  he  therefore  calls  on  C's  account,  or  by 
this  time  A  may  have  paid  again.  In  all  cases  it  will  be 
found  that  the  amount  grows  larger  and  larger  until  in 
many  cases  the  discovery  is  forced  without  the  aid  of  an 
outside  auditor.  In  more  cases,  however,  it  goes  on  for 
years  and  unfortunately  more  than  once  such  a  practice 
has  been  in  full  force  during,  prior,  and  subsequent  to, 
periodical  audits  by  public  accountants. 

Confirmations  of  Outstandings 

The  best  way  to  detect  such  a  defalcation  is  for  the 
auditor  to  send  out  statements  to  all  customers,  request- 
ing them  to  confirm  the  accuracy  of  the  balance  on  a  blank 
inclosed  for  the  purpose,  which  in  turn  is  returned  direct 
to  the  auditor's  office.  This  is  the  practice  followed  by 
many  leading  auditors,  and  where  the  client  does  not  or 
will  not  consent  to  such  a  course,  the  responsibility  for 


320 


AUDITING 


the  integrity  of  the  customers'  balances  is  squarely  up  to 
him.  Every  year  the  objections  to  this  practice  grow  less, 
and  no  doubt  within  a  few  years  the  verification  of  cus- 
tomers' outstanding  balances  by  correspondence  with  the 
auditor  will  be  the  rule  rather  than  the  exception. 
The  old  form  was  substantially  as  follows  v 

Dear  Sirs  : 

In  making  our  periodical  audit  of  the  accounts  of 

we  desire  to  verify  the  accounts  receivable  by  direct  correspondence 
with  each  customer,  and  we  are  therefore  sending  you  (attached  below) 
a  memorandum  of  your  balance,  which  we  would  ask  you  to  kindly 
compare  with  your  books,  advising  us  as  to  its  correctness  or  otherwise. 

If  the  balance  does  not  agree,  please  inform  us  fully  as  to  the 
reason  and  amount  of  the  differences. 

A  stamped  envelope  is  inclosed  for  use  in  replying. 
Very  truly  yours. 


•  Certified  Public  Accountants. 

Perforations  here 

No 191 

The  balance  of  $ under  date  of 

charged  against  my  account  on  the  books  of is  correct. 

Very  truly  yours, 

The  above  form,  or  some  variation  of  it,  was  used 
extensively  for  several  years,  but  it  was  found  to  be  expen- 
sive and  not  entirely  satisfactory.  The  fact  is  that 
where  balances  are  correct  there  is  no  necessity  for  an 
acknowledgment. 

The  most  popular  form  at  present  is  as  follows: 


PLEASE  EXAMINE 

this  Statement  carefully.      If  it  is  not  correct,  please 

communicate  DIRECT  with  our  Auditors, 

LYBRAND,  ROSS  BROS.  &  MONTGOMERY 

55  LIBERTY  ST.,  NEW  YORK, 

giving  full  details  of  any  differences. 


THE    DETAILED    AUDIT 


321 


It  consists  merely  of  a  rubber  stamp  used  on  the  regu- 
lar statement  forms  of  the  concern  under  audit  and  is  more 
effective  than  any  other  method. 

It  is  advisable  for  the  auditor  to  furnish  to  the  client 
envelopes  having  the  auditor's  return  address  thereon; 
otherwise  statements  of  accounts  apparently  genuine,  but 
actually  fictitious,  may  be  returned  to  the  client's  office 
undelivered  by  the  post-office,  and  thus  reach  the  clerk 
responsible  for  the  fictitious  accounts.  If  this  happens, 
the  clerk  will,  of  course,  destroy  the  envelope  and 
statement. 

The  statements  are,  of  course,  prepared  in  the  client's 
office  in  the  usual  manner — not  by  the  auditor.  The 
latter,  however,  should  compare  balances  with  ledger 
accounts  before  maiUng  and  the  mailing  should  be  done 
by  the  auditor.  For  some  accounts  no  statements  are 
sent  and  a  list  thereof  should  be  prepared  and  approved 
by  the  proper  authority.  Some  auditors  object  to  this 
procedure  on  the  ground  that  customers  who  are  in  the 
habit  of  visiting  the  cHent's  place  of  business  are  apt  to 
disregard  the  request  to  take  up  differences  direct  with 
the  auditor  and  in  most  cases  will  report  direct  to  the 
bookkeeper  any  discrepancies.  Even  where  customers 
are  not  accustomed  to  calling  at  the  client's  office  they 
still  insist  on  writing  direct  in  connection  with  anything 
which  concerns  their  accounts,  as  they  do  not  or  will  not 
appreciate  the  value  of  an  independent  check.  The 
auditor,  therefore,  cannot  depend  on  having  reported  to 
him  all  discrepancies  in  customers'  accounts  through  the 
plan  suggested  above.  As  a  practical  matter,  however, 
the  scheme  will  bring  to  light  any  systematic  fraud,  be- 
cause all  customers  do  not  object  to  communicating  direct 
with  an  auditor  and  if  a  bookkeeper  has  been  systemati- 
cally manipulating  customers'  accounts,  one  or  more  can 


322 


AUDITING 


be  depended  upon  to  so  advise  the  auditor,  in  which  case 
the  latter  is  put  on  notice  and  other  instances  of  fraud 
should  be  looked  for. 

It  has  been  found  that  this  independent  check  is  of 
value  not  only  in  the  disclosure  of  fraud,  but  also  in  the 
insight  which  it  gives  as  to  the  condition  of  the  accounts 
with  respect  to  unadjusted  items,  allowances,  etc.  It  is 
needless  to  say  that  some  bookkeepers  are  careless  and 
others  lazy,  and  where  this  is  so  it  is  important  for  the 
auditor  to  find  it  out.  In  all  classes  of  business  various 
claims  and  errors  crop  out  from  time  to  time.  Where 
these  affect  customers'  accounts,  adjusting  entries  should 
be  made  at  once,  otherwise  the  outstanding  balances  do 
not  reflect  the  true  state  of  the  accounts.  If  a  bookkeeper 
is  lazy  or  careless  it  will  soon  develop  in  the  replies  from 
customers  to  the  requests  for  confirmations.  In  several 
instances  this  inquiry  has  demonstrated  a  very  unsatis- 
factory condition  where  the  cause  was  carelessness  and 
not  fraud.  In  many  instances,  however,  carelessness  leads 
to  fraud.  The  very  nature  of  a  business  will  suggest  to 
an  intelligent  auditor  practically  every  source  of  revenue, 
special  and  ordinary. 

Where  the  auditor  can  check  loose  methods  he  may 
really  be  preventing  fraud,  and  the  auditor  who  prevents 
fraud  is  a  very  useful  person. 

It  is,  of  course,  impossible  in  a  limited  space  to  sug- 
gest more  than  a  bare  outline  of  the  procedure  to  be  fol- 
lowed in  ascertaining  that  all  income  has  been  accounted 
for. 

Income  from  Investments 

As  mentioned  elsewhere,  it  is  now  a  frequent  practice 
for  mercantile  and  manufacturing  firms  and  corporations 
to  invest  a  part  of  their  surplus  in  income-bearing  securi- 


THE    DETAILED    AUDIT  323 

ties.  By  reason  of  the  fact  that  these  investments  are 
outside  the  usual  transactions,  the  income  therefrom  is 
not  usually  subjected  to  internal  audit. 

The  auditor  will  obtain  a  schedule  of  all  securities  held 
during  the  period  of  the  audit  and  will  ascertain  that  all 
dividends  or  interest  accruing  thereon  is  properly  ac- 
counted for.  If  any  of  the  investments  are  in  inactive 
stocks  and  the  dividends  thereon  are  irregular  and  cannot 
be  verified  through  the  usual  channels,  a  schedule  of  col- 
lections should  be  compiled  and  submitted  for  approval 
to  some  one  in  authority. 

Where  the  investments  are  all  grouped  in  one  account, 
attention  should  be  called  to  the  desirability  of  opening  a 
separate  account  with  each  one,  and  noting  at  the  top  of 
the  page  full  particulars  as  to  the  serial  numbers  of  the 
bonds  or  stock  certificates,  together  with  interest  or  divi- 
dend dates  and  similar  information.  If  numerous,  it 
would  be  best  to  have  a  subsidiary  ledger  or  record  for 
these  details. 

Interest  Receivable 

Attention  is  called  to  remarks  under  "Interest  Pay- 
able" (page  159)  and  to  Chapter  XV,  where  it  is  shown 
that  considerable  carelessness  exists  with  respect  to  the 
collection  and  payment  of  interest,  and  to  the  danger 
of  accepting  bankers'  figures  as  infallible. 

Interest  on  mortgage  investments  should  be  verified, 
as  shown  under  "Income  from  Investment"  (page  322). 

Interest  on  other  loans  where  the  interest  rate  and 
other  conditions  are  not  always  fixed  in  advance  demands 
more  attention.  Few  businesses  exist,  particularly  those 
conducted  by  firms  and  individuals,  where  private  loans 
or  advances  do  not  appear.  These  may  be  to  friends,  or 
business  associates,  or  to  employees,  or  to  customers  who 


324 


AUDITING 


request  temporary  accommodations.  More  frequently 
they  will  represent  investments  entirely  outside  the  busi- 
ness and  in  connection  with  enterprises  about  which  little 
is  known. 

Any  auditor  who  has  had  long  experience  can  recall 
innumerable  instances  where  men  have  made  fortunes  in 
their  own  business  and  have  squandered  their  entire  sur- 
plus, and  often  most  of  their  capital,  in  mines,  plantations, 
patents,  and  all  sorts  of  industrial  flotations  about  which 
they  had  no  technical  knowledge  whatever. 

Frequently  these  outside  ventures  commence  with 
small  loans,  and  it  is  here  that  the  auditor  can  sometimes 
be  of  real  service  to  his  cHent.  The  client  should  be  im- 
pressed with  the  necessity  of  keeping  his  own  capital 
intact,  and  should  not  have  so-called  investments  in  loans 
to  others  while  borrowing  himself.  The  auditor  should 
point  out  to  the  client  that  he  is  not  a  banker,  but  that 
if  loans  or  advances  are  made  to  others,  interest  thereon 
at  current  rates  should  be  paid  promptly  and  that  the 
loans  should  be  cleaned  up  or  materially  reduced  periodi- 
cally— ^just  as  is  required  by  a  banker.  Considerable  space 
is  devoted  to  this  matter  here  because  borrowers  of 
this  class  are  not,  as  a  rule,  prompt  in  paying  interest, 
so  that  the  failure  to  discover  such  collections  will  give 
an  auditor  a  good  opportunity  to  criticize  unbusinesslike 
practices. 

Interest  on  bank  deposits  is  not  often  inquired  into, 
yet  it  may  be  that  credit  is  being  given  at  2  per  cent  when 
2^  or  3  per  cent  may  have  been  arranged.  Therefore 
the  auditor  should  always  verify  the  rate  actually  in  force. 
A  rough  calculation  can  usually  be  made  with  respect  to 
the  amount  credited  on  balances.  Cheques  issued  follow 
a  well-defined  course,  except  in  special  cases,  so  that  the 
test  of  a  month  or  two,  based  on  average  daily  balances, 


THE    DETAILED    AUDIT  325 

will  disclose  whether  or  not  the  amount  received  is  ap- 
proximately correct.  The  auditor  can  often  have  one  of 
the  ofifice  staff  compile  these  figures  and  thus  reduce  his 
own  time  thereon  to  a  minimum. 

Discount  for  Prepayment 

There  is  some  difference  between  interest  received  on 
notes  receivable  from  customers  and  cash  discounts 
allowed  by  creditors  for  prompt  or  anticipated  cash  pay- 
ments, although  theoretically  they  both  represent  a  profit 
or  return  upon  the  capital  invested  in  the  business.  In 
one  case  the  amount  collected  is  almost  invariably  calcu- 
lated at  the  legal  rate  of  interest  and  is  in  effect  an  offset 
to  the  interest  paid  upon  money  borrowed.  This  will  be 
apparent  if  the  possibility  of  discounting  the  notes  receiv- 
able is  taken  into  consideration,  in  which  case  the  interest 
on  the  notes  is  added  to  the  face  of  the  notes  and  the 
bank  discount  is  deducted  therefrom.  It  is  not  customary 
or  necessary  to  credit  the  interest  to  one  account  and 
charge  the  discount  to  another  account. 

The  rate  of  interest  allowed  for  prepayments  is  purely 
arbitrary  and  fluctuates  to  a  considerable  extent.  Most 
concerns  wish  to  know  the  amount  realized  from  this 
source  and  a  separate  ledger  account  should  be  kept  for  it. 

Trade  Discounts 

Trade  discounts  are  direct  deductions  from  the  pur- 
chases on  one  hand  and  from  the  sales  on  the  other.  That 
is,  no  ledger  account  should  be  kept  for  trade  discounts, 
and  the  term  itself  rarely  appears  in  books  of  account. 

The  test  of  a  trade  discount  is  the  rate.  In  some  lines 
of  business  a  discount  of  7  per  cent  is  allowed  for  payment 
within  thirty  days.  This  is  not  a  cash  discount,  as  no 
business  house  would  pay  the  rate  for  money  which  is 


326  AUDITING 

implied  by  the  rate  of  discount.  Therefore,  the  concern 
which  receives  the  discount  cannot  credit  it  as  an  interest 
earning.  As  a  matter  of  fact,  it  is  a  common  occurrence 
for  notes  to  be  given,  in  which  case  the  7  per  cent  is 
deducted  from  the  face  of  the  bill  and  interest  at  the  rate 
of  6  per  cent  per  annum  added  to  the  balance  for  the 
term  of  the  note.  This  clearly  establishes  the  fact  that 
the  deduction  represents  a  trade  and  not  a  cash  discount. 

The  distinction,  therefore,  is  based  on  the  answer  to 
the  query:  Is  the  rate  one  which  is  obviously  granted  for 
anticipation  of  obligations  not  due?  For  instance,  the 
strict  enforcement  of  the  terms  ''2  per  cent  ten  days,  net 
thirty  days"  indicates  that  the  2  per  cent  is  an  earning 
and  not  a  deduction  from  the  purchase  price.  As  a  gen- 
eral rule  any  discount  in  excess  of  the  terms  just  men- 
tioned may  be  treated  as  a  trade  discount. 

For  an  argument  in  favor  of  entering  trade  discounts 
in  the  books  of  account,  see  page  227. 

Rents  Receivable 

Where  the  item  of  income  from  rentals  is  inconsider- 
able the  records  relating  thereto  are  not  apt  to  be  in 
good  condition  for  auditing. 

In  the  first  place  a  complete  list  of  all  rentable  prop- 
erty is  essential,  and  next  in  importance  is  a  schedule  of 
rentals  which  should  be  received  therefrom.  With  these 
two  points  covered  the  auditor  can  make  a  satisfactory 
audit.  The  premises  should  be  inspected  and  note  made 
of  vacancies,  if  any.  Vacancies  during  the  period  should 
be  listed  and  verification  secured  from  some  source  inde- 
pendent of  the  clerk  in  charge  of  the  collections. 

The  author  had  nearly  completed  the  audit  of  a  small 
railroad  company  when  this  question  arose.  The  balance 
sheet  disclosed  the  ownership  of  some  rentable  buildings. 


THE    DETAILED    AUDIT  327 

When  asked  for  the  records  relating  thereto,  the  treas- 
urer attempted  to  defer  the  inquiry,  but  after  a  list  was 
secured  and  the  possible  income  calculated;  he  confessed 
that  he  had  misappropriated  most  of  the  rent  collections. 
The  amount  was  comparatively  small — a  few  hundred  dol- 
lars out  of  total  income  of  several  millions — but  the  ordi- 
nary income  was  controlled  and  checked  by  other  depart- 
ments and  he  seized  the  only  opportunity  for  fraud  which 
seemed  safe. 

Where  collections  are  in  the  hands  of  reputable  agents, 
who  render  periodical  statements,  it  will  not  be  necessary 
to  check  the  income  in  so  much  detail,  but  careful  inquiry 
should  be  made  to  satisfy  the  auditor  that  the  agent  has 
charge  of  all  the  property,  and  that  the  statements,  when 
received,  are  checked  both  as  to  collections  and  deduc- 
tions. It  is  obvious  that  the  auditor  will  trace  into  the 
cash  receipts  the  total  amount  turned  over  by  the  agent 
for  the  entire  period,  and  if  there  is  the  slightest  doubt 
as  to  the  genuineness  of  the  statements  submitted,  the 
auditor  should  request  the  agent  to  hand  him  a  memoran- 
dum of  payments  for  the  period. 

Realizations  from  Items  Previously  Charged  to  Profit  and 
Loss  * 

Among  the  miscellaneous  items  of  income  which  may 
be  found  in  almost  any  business,  and  to  which  the  auditor 
should  pay  particular  attention  (chiefly  because  it  may  not 
be  expected),  are  subsequent  realizations  from  assets 
which  had  been  charged  ofT  to  profit  and  loss  as  uncol- 
lectable.  The  procedure  is  not  so  difficult  as  it  appears  at 
first  sight,  because  the  number  of  debits  to  profit  and 
loss  over  a  period  of  years  is  not  usually  very  great,  and 
as  only  a  small  proportion  of  these  items  can,  in  any  event, 
admit  a  subsequent  realization,  it  will  not  be  mvicb  of  a 


328 


AUDITING 


task  for  an  auditor  to  analyze  the  ''possible"  items  and 
scrutinize  them  with  the  sole  object  in  view  of  probable 
or  possible  collections. 

Customers'  accounts  are  the  most  prolific  source  of 
delayed  realization,  as  they  are  often  written  off  after 
bankruptcy  proceedings  have  been  instituted,  and  before 
the  final  dividend  has  been  paid. 

Some  bankruptcies  extend  over  a  long  period  of  years, 
so  that  every  such  account  written  off  should  show  beyond 
any  doubt  that  a  final  dividend  has  been  received.  Where 
accounts  have  been  written  ofif  without  any  evidence  that 
bankruptcy  proceedings  were  ever  started,  the  written 
authority  for  such  action  should  be  submitted  to  the 
auditor. 

Stocks,  bonds,  loans  receivable,  and  similar  items  are 
sometimes  written  off  before  the  properties  or  persons 
represented  thereby  have  finally  been  adjudicated  bank- 
rupt or  otherwise  definitely  declared  to  be  hopeless.  This 
line  of  inquiry  does  not  require  much  time,  but  experience 
has  proved  its  worth. 

Consignments  and   Goods   Out   on  "Memorandum" 

As  carelessness  is  apt  to  exist  in  connection  with  all 
transactions  which  are  out  of  the  regular  routine,  the 
auditor  should  carefully  inspect  the  records  relating  to 
charging  out,  keeping  track  of  and  collecting  the  pro- 
ceeds of  goods  sent  out  on  "memorandum"  or  "on  sale," 
both  of  which  are  trade  terms  for  consignments. 

If  not  charged  to  the  regular  ledger  account  of  the 
consignee  (which  may  be  inadvisable),  the  record  of  out- 
standings should  be  kept  in  a  substantial  loose-leaf  binder 
in  form  and  in  dignity  equal  to  the  ordinary  customers 
ledgers. 

It  is  neces3ary  to  create  an  impression  of  permanence 


THE    DETAILED    AUDIT  329 

about  the  records  in  an  office,  or  the  data  which  are  con- 
sidered to  be  temporary  will  be  kept  in  an  unsatisfactory 
and  careless  manner. 

The  record  should  be  looked  upon  as  a  running  ac- 
count and  all  freights,  drayages,  insurance,  and  other 
charges  posted  thereto  as  incurred.  In  support  of  the 
memorandum  or  temporary  records  which  are  in  use,  the 
auditor  should  be  furnished  with  evidence  that  the  terms 
and  conditions  are  in  order.  Usually  the  correspondence 
relating  thereto  will  be  sufficient,  provided  it  carries  the 
authority  of  one  competent  to  fix  such  terms.  A  careful 
test  of  the  accounting  for  the  net  proceeds  as  shown  to 
be  due  by  the  record  just  described  will  then  be  made.  If 
the  test  proves  that  no  loss  is  likely  to  have  occurred, 
there  is  no  necessity  for  a  complete  verification. 

Where  consigned  goods  have  not  been  accounted  for 
when  the  books  are  closed,  the  consignee  should  be  asked 
for  an  account  current  up  to  the  date  of  closing.  Based 
on  this,  credit  may  be  taken  for  the  proceeds  of  sales 
actually  made.  The  balance  will  be  treated  as  stock-in- 
trade  and  valued  on  the  basis  described  on  pages  88-91. 
Goods  which  have  been  charged  out  at  selling  prices  and 
appear  as  accounts  receivable  will  likewise  have  to  be 
treated  as  stock-in-trade  and  the  valuation  adjusted  to  the 
proper  basis  for  balance  sheet  purposes. 

Goods  Received  for  Sale 

Where  the  concern  under  audit  is  the  consignee,  the 
accounts  will  be  handled  differently.  If  the  goods  received 
are  to  be  sold  on  commission  for  account  of  the  consignor, 
then  the  income  will  consist  of  a  commission  on  the  selling 
price,  or  perhaps  the  gross  amount  realized  above  a  cer- 
tain fixed  price,  or  some  one  of  the  many  other  under- 
standings upon  which  consignments  are  received. 


330 


AUDITING 


The  auditor  must  have  access  to  the  exact  contract 
between  the  parties  in  order  to  test  the  accuracy  of  this 
income.  In  many  cases  the  agreements  are  verbal  or  are 
based  on  correspondence  more  or  less  conflicting  as  to 
definite  terms.  Misunderstandings  frequently  arise  be- 
tween the  consignor  and  the  consignee,  due  principally  to 
the  failure  of  the  minds  to  meet  before  the  contractual 
relations  commence.  The  auditor  will  usually  have  an 
opportunity  to  urge  the  desirability  of  an  explicit  contract 
being  entered  into  at  the  outset  and  the  furnishing  of  a 
copy  to  the  client's  office,  so  that  the  terms  and  conditions 
of  each  consignment  may  be  noted  in  the  books.  Where 
a  consignment  is  only  partially  disposed  of  when  the 
books  are  closed,  care  must  be  taken  that  the  unsold 
goods  are  not  included  in  the  inventory.  A  record  of  the 
quantities  on  hand  should  be  made,  but  the  values  should 
be  entered  'in  short"  and  a  memorandum  made  that  the 
items  belong  to  the  consignor. 

Inquiry  should  be  made  as  to  whether  such  goods  are 
insured,  and  if  so,  in  whose  name.  If  in  the  name  of  the 
consignee,  the  policies  must  contain  a  stipulation  covering 
the  facts  of  title. 

On  lots  partly  disposed  of,  credit  may  be  taken  for  the 
proportionate  commission  or  profit  on  goods  sold  and 
delivered,  but  no  income  should  be  taken  credit  for  on 
unsold  or  undelivered  goods.  In  order  to  satisfy  himself 
that  the  accounts  are  in  order  the  auditor  should  request 
that  pro  forma  account  sales  be  made  up  for  all  open  con- 
signments. The  quantities  not  yet  disposed  of  should  be 
checked  with  the  inventories  and  the  accrued  earnings 
can  also  be  verified. 

The  account  sales  should  be  scrutinized  in  order  to  see 
that  all  legitimate  charges  are  made  to  the  consignor. 
Commissions  and  freights  are  not  usually  forgotten,  but 


THE    DETAILED    AUDIT 


331 


careless  clerks  do  not  always  include  insurance,  cartage, 
allowances,  and  similar  items  which  may  be  permissible. 
Other  items,  such  as  extra  charges  for  special  services, 
postage,  etc.,  may  not  be  thought  of,  but  as  items  of  this 
nature  are  charged  by  some  commission  houses,  it  is 
always  pertinent  to  inquire  whether  the  matter  has  had 
full  consideration. 

Sales  Not  Delivered 

In  closing  books  there  seems  to  be  a  temptation  on 
the  part  of  most  concerns  to  anticipate  all  profits  in  sight. 
Therefore,  where  sales  have  been  made  for  future  delivery, 
the  tendency  is  to  charge  the  goods  and  create  an  account 
receivable  or  make  some  adjustment  of  the  profit  and  loss 
account  to  include  the  profit  which  it  is  expected  will  be 
realized.  Conservative  business  men  do  not  follow  this 
course,  but  experience  proves  that  it  is  followed  often 
enough  to  compel  an  auditor  to  be  constantly  on  his 
guard. 

In  the  automobile  trade,  for  instance,  sales  are  effected 
and  substantial  deposits  or  part  payments  received  long 
before  the  cars  are  delivered.  But  no  profit  has  been 
realized  and  may  never  be  realized,  so  that  the  inclusion  of 
this  hoped-for  profit  in  a  profit  and  loss  account  is  abso- 
lutely wrong. 

Thousands  of  such  sales  are  never  consummated  by 
reason  of  the  failure  of  the  factories  to  build  the  cars.  The 
sales  have  been  canceled  and  the  deposits  returned,  and 
all  expenses  incurred  thereby  have  not  been  compensated 
for. 

In  other  cases  the  goods  may  be  on  hand  or  in 
process  of  manufacture,  so  that  the  expectation  of  be- 
ing able  to  deliver  is  based  on  a  sounder  hypothesis, 
but    the    rule    is    precisely    the    same.      No    profit    must 


332 


AUDITING 


be  taken  until  a  delivery  or  a  tender  has  been  made 
and  the  sale  is  converted  into  a  valid  claim  against  a  solvent 
debtor. 

There  is  some  merit  in  the  contention  that  where  sales 
for  future  delivery  have  been  made,  and  the  goods  are  on 
hand  ready  to  ship,  the  goods  may  be  inventoried  at  some- 
thing more  than  manufacturing  cost.  That  is,  the 
expenses  of  sale  having  been  incurred  to  this  extent,  the 
period  in  which  delivery  is  made  should  be  forced  to  bear 
its  share  of  the  burden,  and  such  expenses  should  be  car- 
ried forward  as  an  asset  under  the  caption  ''Deferred 
Charges  to  Operations."  These  may  include  such  sales  ex- 
penses as  commissions,  salaries,  advertising  and  traveling 
expenses,  etc.,  but  must  not  include  any  part  of  fixed  charges 
such  as  rent,  administration  expenses,  etc. 

Where  part  of  the  sales  price  has  been  collected  in 
advance  or  deposits  have  been  received,  such  items  should 
be  separately  stated  on  the  balance  sheets,  as  they  do  not 
constitute  trade  liabilities,  but  on  the  contrary  are  evi- 
dences of  prospective  profits.  But  as  already  stated,  the 
prospective  profit  must  not  be  anticipated,  and  if  sales 
not  delivered  have  been  charged  to  customers,  the  auditor 
should  eliminate  such  items  from  the  accounts  receivable 
and  the  sales  account  and  add  the  goods  to  the  inventory 
at  their  cost. 

There  may  be  many  a  slip  between  the  order  and  the 
profitable  closing  of  the  transaction,  as  Judge  Clark  said 
in  the  American  Malting  case: 

These  contracts  were  to  deliver  at  a  future  time  a  product  not  yet 
made,  from  raw  material,  not  yet  purchased,  with  the  aid  of  labor  not 
yet  expended.  The  price  agreed  to  be  paid  at  that  future  time  had  to 
cover  all  the  possible  contingencies  of  the  market  in  the  meanwhile  and 

might  show  a  profit,  and  ran  the  chance  of  showing  a  loss You 

cannot  make  a  dividend  of  a  hope  based  upon  an  expectation. 


THE    DETAILED    AUDIT 


333 


Sales  of  Building  Lots 

In  the  audit  of  a  land  or  real  estate  company  it  would 
at  once  occur  to  the  auditor  that  he  must  look  carefully 
for  receipts  from  sales  of  building  lots.  Now  the  last 
places  to  look  at  are  the  receipt  side  of  the  cash  book  and 
the  sales  book  or  other  record  of  the  sales,  although  when 
he  asks  for  a  record  of  sales,  that  is  the  point  to  which 
he  will  be  directed,  and  at  least  nine  out  of  ten  times 
the  client  will  expect  him  to  take  these  records  as  starting- 
points  rather  than  to  consider  such  a  record  as  a  goal 
tozvard  which  he  is  working. 

There  probably  never  has  been  a  land  company  which 
did  not  issue  a  map  of  its  property  nicely  marked  off  into 
lots  with  a  number  and  block  for  every  lot.  What  could 
be  simpler  than  for  the  auditor  to  take  a  map  and  one  of 
the  printed  price  lists  usually  available  and  proceed  to 
account  for  every  lot?  All  lots  sold  for  less  than  list  price 
should  pass  inspection  by  a  duly  authorized  officer.  All 
lots  not  accounted  for  as  sold  should  be  on  the  *'for  sale" 
list  or  else  specified  as  being  set  apart  for  particular  pur- 
poses, these  purposes  to  be  evidenced  by  resolutions  of  the 
board  of  directors  or  other  authority  properly  expressed. 

As  most  lots  are  sold  on  instalments,  the  auditor  wall 
then  look  for  collections  of  interest  on  the  deferred  instal- 
ments and  will  require  that  every  such  item  be  accounted 
for. 

And  so  through  the  rather  simple  processes  of  most 
business  enterprises  it  will  be  possible  to  think  out  the 
sources  of  revenue  instead  of  using  the  books  as  a  guide, 
for  by  so  doing  the  auditor  will  avoid  the  danger  of  being 
influenced  by  the  entries  which  are  shown  therein  and  thus 
lose  sight  of  the  fact  that  those  entries  are  not  all  which 
should  appear. 


CHAPTER    XVI 

THE  DETAILED  AUDIT   (Continued) 


PURCHASES  AND  EXPENSES 
Vouchers 

It  must  be  admitted  that  the  examination  of  vouchers 
is  necessary  and  valuable,  but  with  respect  to  relative 
importance,  such  work  will  be  classified  down  toward  the 
end  of  the  list.  If  a  careful  comparison  of  vouchers  with 
cash  books  would  disclose  improper  or  extravagant  pur- 
chases or  expenses,  the  very  considerable  work  mvolved 
would  be  justified,  but,  unfortunately,  the  ordinary 
voucher,  so-called,  is  usually  little  more  than  a  receipt  for 
a  given  sum  of  money  and  is  usually  of  so  little  practical 
use  that  many  concerns  never  insist  on  vouchers  nor  do 
they  preserve  them  when  they  are  furnished. 

Of  course,  this  is  a  matter  which  should  not  be  dis- 
cussed with  anyone  whose  accounts  are  being  audited. 
Where  vouchers  are  taken,  an  auditor  should  call  for 
vouchers  covering  all  payments  and  require  that  they  be 
arranged  in  order  to  correspond  with  the  cash  book 
entries.  He  should  not  allow  it  to  be  knov/n  that  there 
is  any  probability  of  his  not  checking  any  part  of  the 
vouchers,  or  it  will  be  difficult  to  secure  them  properly 
and  have  them  arranged  in  order.  If  a  cheque  bears  on  its 
face  or  back  any  indication  of  its  purpose,  it  is  the  best 
receipt  for  money  paid  that  can  be  secured.  If  it  bears 
no  evidence  as  to  its  purpose,  but  can  be  readily  identified 

334 


THE    DETAILED    AUDIT  335 

with  a  particular  bill  or  invoice,  it  still  is  a  better  voucher 
than  a  receipted  bill.  The  comparison  of  vouchers  with  a 
cash  book  without  the  identification  of  the  entries  in  the 
cash  book  with  the  cheques  is  worse  than  negligence,  for 
the  sole  purpose  of  vouching,  cash  is  to  ascertain,  as  nearly 
as  possible,  that  the  payments  represent  an  equivalent  in 
value  to  the  payers  and  that  the  equivalent — that  is,  the 
discharge  of  a  like  liability — is  received*  when*  the  cash  is 
paid.  A  mere  receipt  for  so  much  money,  w-hich  can  read- 
ily be  forged,  is  poor  evidence  of  a  legitimate  payment, 
])ut  a  paid  cheque,  properly  indorsed  and  otherwise  iden- 
tified as  representing  a  definite  liability,  is  pretty  fair  proof 
that  the  money  has  reached*  a  creditor;  and  if  the  auditor 
follows  it  up  by  a  careful  scrutiny  of  the  documents 
supporting  the  cheque,  he  is  on  the  right  track. 

It  must  be  remembered,  however,  that  a  paid  cheque 
unsupported  by  other  documents  is  not  conclusive 
evidence  of  the  propriety  of  a  payment.  This  is  well 
illustrated  by  the  following  instance  in  the  author's 
experience: 

The  accounts  of  a  district  school  board  which  had 
passed  out  of  existence  were  to  be  audited.  Only  a  small 
amount  of  the  funds  was  handled,  the  total  collection  of 
taxes  for  district  school  purposes  being  about  $15,000  per 
annum.  The  records  submitted  to  the  auditors  were  fairly 
complete,  with  the  exception  that  no  paid  bills  were 
turned  over  to  the  new  board.  The  paid  cheques,  how- 
ever, were  intact,  the  cash  book  had  been  well  kept,  with 
some  attempts  at  classification  of  expenditures,  and  the 
minute  book  contained  complete  lists  of  all  the  bills 
approved  for  payment  by  the  board  at  its  meetings. 

Every  disbursement  recorded  in  the  cash  book  was 
found  to  be  supported  by  a  paid  cheque,  and  all  the 
payments  had  been  duly  authorized  by  the  board.     Most 


33^ 


AUDITING 


of  the  payments  were  of  very  moderate  amounts,  and  thus 
far  everything  appeared  to  be  in  ordier.  Practically 
nothing  had  been  seen  to  arouse  the  auditor's  suspicions. 
Several  payments,  each  for  a  Httle  less  than  $150,  had, 
however,  been  made  to.  a  wholesale  drug  house  and  a 
pharmacist  respectively.  The  auditors  could  not  think 
what  articles  aside  from  sponges  would  be  purchased  from 
these  sources,  and  concluded  to  obtain  duplicate  bills  so 
as  to  ascertain  the  nature  of  the  articles  purchased.  The 
request' for  such  bills  was  in  both  cases  met  with  the  reply 
that  no  payment  of  the  amount  mentioned  had  been 
received  from  the  school  board.  Further  investigation 
developed  the  fact  that  the  indorsements  on  the  cheques 
had  been  forged,  which  fact  the  auditor  could  not  know 
from  an  examination  of  the  cheques  themselves,  as  they 
bore  evidence  of  having  passed  through  bank  in  the  usual 
way.  It  finally  developed  that  the  indorsements  had  been 
forged  by  a  member  of  the  school  board. 

Furthermore,  even  a  bill  certified  as  to  receipt  of  the 
articles  shown  thereon,  approved  for  payment*  by  the 
authorized  of^cials,  and  evidenced  as  to  actual  payment 
by  an  indorsed  cheque  which  has  passed  through  bank  in 
the  regular  manner,  may  not  be  conclusive  evidence  of 
the  honesty  of  a  transaction.  Another  schooil  board  (not 
the  one  mentioned  in  the  preceding  paragraphs)  had  pur- 
chased a  piano  for  $450.  The  documents  supporting  the 
payment  were  all  in  regular  order,  and  the  piano  itself 
was  in  existence  as  proof  of  the  fact  that  the  article 
charged  for  on  the  bill  had  actually  been  received.  The 
auditors,  however,  made  a  personal  visit  to  the  store  where 
the  piano  had  been  purchased  and  without  revealing  their 
identity  made  inquiries  as  to  the  prices  of  various  styles 
of  pianos.  They  were  offered  exactly  the  same  style  of 
piano  for  which  the  school  board  had  paid  $450  for  $275, 


THE    DETAILED    AUDIT 


337 


and  this  without  any  "haggling"  over  the  price.  The 
piano  concern  later  admitted  that  when  it  received  the 
school  board's  cheque  for  $450,  it  (the  piano  concern) 
paid  $200  in  currency  to  the  bearer  of  the  cheque.  Of 
course,  the  "refund"  never  found  its  way  back  into  the 
school  board  treasury. 

In  small  concerns  many  items  of  payment  will  be 
posted  direct  to  expense  and  other  general  ledger 
accounts.  The  vouchers  for  such  items  should  include 
complete  evidence  of  being  genuine.  The  best  vouchers 
for  payments  posted  direct  to  personal  accounts  are  the 
paid  indorsed  cheques,  because  the  credit  side  of  the  per- 
sonal ledger  accounts  will  have  been  compared  with  the 
original  invoices,  so  that  very  little  evidence  of  the 
discharge  of  the  obligation  is  required. 

An  auditor  can  be  of  great  assistance  to  his  client  by 
looking  into  the  various  operations  surrounding  a  pay- 
ment as  well  as  passing  on  the  question  as  to  whether  or 
not  it  is  a  bona  fide  transaction. 

Purchase  Invoices 

The  bill  or  invoice  should  bear  on  its  face  all  the 
proper  marks  or  initials  to  indicate  that  the  goods  or 
materials  were  received  in  proper  order  as  to  quality  and 
quantity;  that  they  were  as  ordered,  which  includes  an 
approval  of  the  price,  provided  it  was  recorded  at  the 
time  the  order  was  given,  or  an  approval  by  a  responsible 
and  authorized  official  where  the  price  was  not  fixed  in 
advance;  that  if  the  quotation  was  ''delivery  free,"  freight 
was  not  paid,  or,  if  paid,  has  been  charged  back  to  the 
vendor;  that  where  custom  permits  or  any  other  indica- 
tion appears  of  a  cash  discount  being  in  order,  it  was 
deducted;  that  in  all  other  respects  the  purchase  was  in 
order,   including   the   checking   of   the   calculations,    the 


^;^g  AUDITING 

notations  as  to  the  department  or  account  to  be  charged, 
etc. 

Inquiry  should  be  made  as  to  whether  the  receiving- 
clerks  keep  an  independent  record  of  all  goods  received 
irrespective  of  invoices  to  cover,  and  whether  the 
subsequent  comparison  of  these  records  is  carried  out 
intelligently  and  completely. 

As  stated  above,  these  invoices  should  be  thoroughly 
tested  to  ascertain  the  internal  method  of  checking  their 
accuracy,  but  the  auditor  should  never,  as  a  matter  of 
course,  attempt  to  verify  the  whole  of  the  purchase 
vouchers  unless  he  has  a  further  purpose  in  view  than  to 
"audit  the  books."  In  a  large  concern  the  auditor  does 
not  think  of  examining  every  purchase  invoice.  He  makes 
copious  tests  and  if  nothing  suspiciaus  is  discovered,  is 
willing  to  certify  that  the  accounts  are  correct.  An 
auditor  should  not  inspect  every  voucher  even  in  a  small 
establishment  unless  there  is  some  special  reason  for 
doing  so. 

There  are  many  more  important  things  to  do  in  an 
audit,  and  the  time  spent  on  vouchers  must  bear  a  proper 
relation  to  the  other  time  and  to  the  fee,  if  it  is  to  be 
fair  to  the  auditor  and  to  the  client. 

It  is  true  that  some  books  and  articles  on  auditing 
recommend  the  examination  of  all  vouchers,  but  these  are 
not  based  on  successful  experience  nor  upon  a  proper 
realization  of  the  service  which  the  client  is  entitled  to 
receive. 

Where  a  system  of  internal  check  is  in  force,  it  will 
not  be  necessary  to  inspect  every  invoice;  a  complete  test 
should  be  made  to  see  that  there  is  a  strict  compliance 
with  the  rule  heretofore  mentioned,  but  this  test  will  be 
complete  by  taking,  say,  three  or  four  months  out  of 
twelve  and  examining  each  item,  always  including  the  last 


THE    DETAILED    AUDIT  339 

month  of  the  period.  The  auditor  should  then  look  over 
the  cash  book  very  carefully  for  the  other  eight  or  nine 
months,  and  in  connection  with  his  analysis  of  the  ledger 
accounts  he  can  note  any  unusual  or  suspicious-looking 
item  and  call  for  the  voucher  covering  it.  This  will 
obviate  the  necessity  of  checking  over  the  mass  of  docu- 
ments which  he  has  satisfied  himself  by  his  general  test 
to  represent  purchases  for  the  proper  and  ordinary 
purposes  of  his  cHent.  The  analysis  of  the  ledger  accounts' 
is  important  wherever  charges  have  been  made  to  plant 
accounts.  These  must  always  be  supported  by  proper 
vouchers. 

In  a  bankruptcy  case  it  was  found  that  the  proprietors 
had  personally  withdrawn  large  sums  and  made  it  appear 
on  the  books  that  equivalent  amounts  were  expended  for 
merchandise.  Cheques  and  cash  received  from  customers 
were  entered  in  the  cash  book  and  credits  posted  to 
customers'  accounts  therefrom.  The  remittances  them- 
selves were  not  deposited  in  the  company's  regular  bank 
account,  but  in  a  secret  bank  in  another  state,  which  latter 
bank  account  was  used  for  the  personal  benefit  of  the 
proprietors.  In  order  that  the  company's  bank  account 
would  be  in  balance,  regular  cheques  were  drawn  to  the 
order  of  fictitious  creditors,  indorsed,  taken  to  the  bank 
and  deposited  in  the  regular  account  to  agree  with  the 
entries  in  the  cash  book  for  the  customers'  cheques.  The 
creditors'  accounts  were  debited  with  the  cash  purported 
to  be  paid  to  them,  and  credited  with  the  fictitious 
purchase  items. 

In  a  defalcation  amounting  to  over  $20,000,  the  cashier, 
in  order  to  conceal  the  embezzlement  of  cash  sales,  drew 
cheques  to  legitimate  creditors  for  amounts  due,  and 
entered  the  payments  in  the  cash  book  $1,000  in  excess  of 
the  correct  amounts.    The  fraud  would  have  been  discov- 


340  AUDITING 

ered  by  comparing  the  cheque  stubs  with  the  cash  book, 
or  by  vouching  all  payments.  Usually,  however,  the 
cashier  selected  but  one  or  two  months  in  each  year  for 
the  fraudulent  entries,  and  an  auditor  who  selected  a  few 
months'  work  out  of  the  twelve  for  a  test,  might  overlook 
the  dishonest  entries. 

The  cashier's  procedure  was  as  follows: 

The  bank  account  was  first  reconciled  with  the  correct 
amounts  appearing  on  the  stubs,  after  which  the  stubs  were 
raised  to  agree  with  the  larger  amounts  in  the  cash  book. 
The  fiscal  year  of  the  concern  ended  the  28th  of  February. 

The  sum  of  $22,800  was  covered  up  as  follows: 

Cheques  to  creditors  were  entered  in  the  cash  book, 
each  $1,000  greater  than  the  correct  amount: 

1910,  May,  one  item 

1911,  Jan.,    one  item 
1911,  Oct.,   two  items 
1914,  Jan.,     five  items 
1914,  Dec,   five  items 

The  cash  book  balance  was  carried  forward  to  the 
beginning  of  the  next  month  insufficient  by  $3,000.  As 
this  would  throw  the  books  out  of  balance,  the  debit 
footing  of  the  merchandise  account  in  the  general  ledger 
was  increased  $3,000. 

The  footing  of  "Merchandise  Purchased"  column  on 
the  payment  side  of  cash  book  was  raised  $2,000. 

The  cash  book  balance  was  reduced  $3,800,  and  the 
debit  item  of  merchandise  purchased,  in  the  journal,  was 
increased  $3,800.  The  credit  posting  to  the  creditors' 
accounts  was  for  the  correct  amount,  i.e.,  $3,800  less  than 
the  entry  first  called  for. 

In  making  the  test  care  must  be  taken  to  ascertain 
that  bills  are  made  out  to  the  concern  under  audit  and 


THE    DETAILED    AUDIT 


341 


not  to  its  officers  or  clerks.  Of  course,  where  the 
disposition  of  the  things  purchased  is  checked  such  an 
irregularity  would  be  disclosed. 

The  names  of  the  payees  may  be  those  with  whom  the 
clerks,  as  well  as  the  concern  itself,  may  possibly  be 
dealing.  In  such  cases  sorrie  extra  precaution  should  be 
used  in  examining  the  original  invoices-  For  instance,  a 
cheque  drawn  to  the  order  of  and  indorsed  by  a  depart- 
ment store  or  a  tax  collector  would  not  be  sufficient 
evidence  as  to  the  propriety  of  the  payment.  If  original 
invoices  of  this  nature  are  said  to  be  missing,  duplicates 
should  be  requested  and  the  auditor  should  not  be  put 
off  with  any  excuse  or  delay  in  securing  them.  Of  course, 
where  the  disposition  of  the  things  purchased*  is  checked, 
any  such  irregularity  would  be  disclosed. 

It  is  important  to  know  not  only  that  the  entries 
purporting  to  represent  purchases  made  are  proper,  but 
that  all  invoices  for  purchases  actually  made  have  been 
entered  previous  to  closing  the  books.  This  can  be  quite 
satisfactorily  tested  where  there  is  an  adequate  system  of 
recording  purchase  orders  issued,  of  keeping  record  of 
incoming  goods,  and  of  checking  invoices  against  order 
and  receiving  records.  The  comparison  of  creditors' 
statements  with  the  accounts  payable  record  should  under 
ordinary  circumstances  also  enable  the  auditor  to  detect 
the  omission  of  purchase  invoices. 

In  the  case  of  Irish  Woolen  Mill  Company,  Lim.,  v. 
Tyson  and  others,  the  auditor  was  held  liable  for  negli- 
gence in  having  failed  to  detect  the  intentional  omission 
of  purchase  invoices  when  the  books  were  closed  and  the 
subsequent  entry  of  the  invoices  in  the  following  fiscal 
period.  The  purpose  of  the  company's  secretary  was  to 
make  a  better  showing  than  its  operations  and  financial 
condition  justified.    The  court  held  that  the  auditor,  who 


A 


342  AUDITING 

had  made  monthly  audits  for  a  number  of  years,  should 
have  had  his  suspicions  aroused  by  the  fact  that  invoices 
were  charged  into  each  period  vi^hich,  according  to  their 
date,  belonged"  in  a  previous  period,  and  that  had  he  then 
made  the  investigation-  which  this  suspicious  circumstance 
called  for,  the  fraud  wouldr  have  been  detected. 

Missing  Vouchers 

These  are  a  source  of  much  needless  work  to  many  au- 
ditors. If  an  audit  is  being  made  and  no  evidence  whatever 
of  fraud  is  found,  and  if  the  payments  for  which  vouchers 
are  not  submitted  appear  in  every  way  to  be  regular,  it  is 
usually  a  waste  of  time  to  list  them  in  detail  and  consume 
a  lot  of  time  in  having  them  located.  In  most  cases  they 
will  not  be  found,  as  many,  vouchers  are  never  returned  or 
are  mislaid  or  lost  in  the  mails. 

No  specific  rule  can  be  formulated  with  respect  to 
missing  vouchers,  but  the  author  wishes  to  go  on  record 
as  opposed  to  the  contention  of  some  auditors  who  regard 
this  point  as  a  very  serious  one  in  every  audit.  The 
experience  of  the  author  has  been  that  where  a  cashier 
enters  an  irregular  or  wholly  fictitious  payment,  he  will 
always  be  sure  to  have  a  voucher  to  cover. 

Vouchers  for  Petty  Cash  Payments,  Pay-Roll,  etc. 

Where  payments  are  made  covering  expenses  and 
wages,  and  for  similar  purposes,  and  where  there  is  no 
ledger  account  with  the  payee,  great  care  must  be  takeii 
to  ascertain  that  the  amounts  have  not  been  overstated, 
either  by  fraudulently  raising  the  figures  on  the  bill  or 
memorandum  or  by  entering  a  larger  amount  in  the  cash 
book  than  the  voucher  represents. 

Petty  Cash 

Vouchers  are  often  altered  and  petty  cash  payments 
Are  frequently  the  subject  of  manipulation.    Junior  clerks 


THE    DETAILED    AUDIT 


343 


see  how  easy  it  is  to  hand  in  a  memorandum  calling  for 
$10  postage  when  $5  is  all  that  is  necessary,  or,  in  fact, 
used,  and  they  gradually  extend  their  field  of  operation 
until  large  sums  are  abstracted.  Postage  or  mail  books 
are  in  general  use  in  England,  and  if  more  generally 
adopted  here  would  save  many  a  boy  from  the  peniten- 
tiary. It  is  a  grave  responsibility  for  any  employer  to 
permit,  or  any  auditor  to  approve,  a  loose  or  inefficient 
system  for  handling  petty  cash,  postage,  etc. 

A  large  percentage  of  young  boys  who  are  employed 
in  the  business  districts  of  our  large  cities  and  who  have 
access  to  or  can  draw  from  petty  cash  funds,  are 
constantly  following  the  races  through  the  worthless 
afternoon  papers,  through  poolrooms,  or  in  other  ways. 
Conversations  in  large  offices  often  indicate  the  keenest 
interest  in  the  results  of  the  races  not  only  near  New 
York,  but  throughout  the  country.  Professional  auditors 
should  take  a  firm  stand  on  all  questions,  public  or  private, 
which  affect  gambling. 

Coming  back  to  petty  cash  vouchers,  in  view  of  the 
informality  of  many  of  them,  the  auditor's  best  protection 
is  to  have  some  responsible  person  scrutinize  the  pay- 
ments, rather  than  the  vouchers  themselves,  and  indicate 
his  approval  by  initialing  each  page  or  each  month  of  the 
petty  cash  book.  The  whole  question  of  petty  cash 
vouchers  is  one  which  calls  for  the  exercise  of  good 
judgment  rather  than  the  application  of  fixed  rules,  and 
the  auditor  should  take  this  view  of  it  rather  than  feel 
that  it  is  merely  a  matter  of  comparing  pieces  of  paper 
with  certain  entries  on  the  payment  side  of  a  cash  book. 

There  is  no  great  objection  to  examining  every 
voucher  where  the  concern  is  not  too  large,  and  where 
the  auditor  has  plenty  of  time,  and  where  he  does  it 
properly,    but    he    should    relegate    the    inspection    of 


344  AUDITING 

vouchers  to  its  proper  place  and,  if  pressed  for  time,  he 
should  attend  first  to  more  important  matters. 

Where  a  test  is  considered  sufficient  the  auditor  may 
verify  all  of  the  vouchers  for  a  certain  period,  or  all 
vouchers  exceeding  a  certain  amount  for  the  entire  period. 
^^^'-There  are  numerous  ways  of  handling  petty  cash,  but 
unfortunately  most  of  them  provide  little  or  no  check 
upon  the  cashier  and  furnish  afterv^ard  no  evidence  of  the 
faithful  discharge  of  his  trust. 

The  method  of  charging  all  petty  expenditures  in  a 
lump  sum  to  an  expense  account  known  as  ''petty 
expenses"  is  a  most  common  one,  and  one  that  is  highly 
undesirable.  Fraud  thereunder  often  occurs.  The  older 
method  of  paying  such  expenses  out  of  incoming  cash  or 
of  cash  received  from  cash  sales,  and  oftentimes  of  not 
making  any  entry  whatever,  is  still  worse. 

The  most  satisfactory  method  is  that  known  as  the 
"imprest"  system.  The  petty  cashier  is  provided  with  a 
fund  of  $100  or  $500,  or  whatever  amount  is  necessary 
to  meet  the  average  expenses  of  two  weeks  or  a  month. 
This  amount,  when  paid  to  him,  is  charged  to  an  account 
in  the  general  ledger  known  as  "Petty  Cash  Fund"  and 
stands  undisturbed  from  month  to  month. 

The  petty  cashier  keeps  a  cash  book  provided  with  a 
column  for  each  of  the  principal  expense  items,  such  as 
office  supplies,  factory  supplies,  postage,  stationery,  and 
printing,  etc.  He  continues  to  pay  from  his  cash  fund 
until  the  balance  gets  low,  or  until  the  end  of  the  month, 
when  he  rules  off  his  book,  presents  it  to  the  cashier 
together  with  his  vouchers,  and  receives  in  exchange  a 
cheque  for  the  exact  amount  of  his  expenses.  This  and 
whatever  cash  balance  he  had  left  make  up  the  original 
petty  cash  fund.  The  general  cashier  in  recording  the 
cheque  on  his  records  does  not  charge  "petty  cash,"  but 


THE    DETAILED    AUDIT  345 

he  charges  the  various  expense  accounts  direct,  posting 
from  the  footings  of  the  columns  in  the  petty  cash  book. 
In  some  instances  a  loose  summary  sheet  is  used  to 
which  the  vouchers  are  attached  and  on  which  they  are 
entered  in  detail.  This  system  does  away  entirely  with 
the  petty  cash  book,  and  the  summary  sheet  and  support- 
ing vouchers  become  the  authority  for  the  issuance  of  a 
refunding  cheque  to  the  petty  cashier. 

Organization  and   Similar   Expenses  Which  Affect  More 
Than  One  Year's  Operation 

If  the  expenses  incurred  in  the  organization  of  the 
company,  such  as  incorporation  fees,  legal,  engineering, 
and  other  expenses,  engraving  bonds  and  stock  certifi- 
cates, transfer  fees  and  stamps,  etc.,  were  more  than  can 
fairly  be  charged  into  current  expenses,  it  was  hitherto 
considered  permissible  to  spread  the  charges  over  a  term 
of  years,  preferably  three,  and  not  more  than  five. 

In  some  respects  sentiment  is  changing  as  to  the 
wisdom  of  spreading  these  expenses  over  more  than  two 
years.  The  best  practice  is  to  charge  ofT  immediately 
everything  which  has  no  tangible  or  residual  value.  It  is 
a  fallacy  to  assume  that  stock  certificates,  incorporation 
expenses,  etc.,  have  any  of  the  attributes  of  an  asset;  and 
so  the  sooner  the  cost  appears  in  the  expense  account 
the  better. 

The  old  theory  of  deferring  part  of  the  charge  to  profit 
and  loss  was  sound  enough  except  that  the  rule  has  been 
abused,  and  we  now  find  apportionments  over  five  years 
or  longer.  In  some  cases  all  organization  expenses,  using 
the  term  in  its  broadest  sense,  are  permanently  capital- 
ized. The  author  advocates  charging  off  all  such  expenses 
as  they  are  incurred. 

But   it   should   be   ascertained   whether   or   not    the 


346 


AUDITING 


promoters  (if  the  enterprise  was  "promoted")  agreed  to 
pay  any  part  of  these  expenses.  This  is  a  matter  of 
increasing  importance,  as  a  number  of  corporations  are 
being  organized  where  this  obligation  is  assumed  by  the 
organizers. 

Other  items,  such  as  advertising  and  exploitation 
expenditures  which  are  intended  to  produce  future  busi- 
ness, may  not  appear  to  be  a  proper  charge  against  income 
which  could  hardly  have  received  the  benefit  of  such 
payments.  An  auditor  may  pass  the  carrying  forward  of 
any  legitimate  expenditure  which  has  been  incurred  solely 
for  the  benefit  of  future  business,  provided  that  in  his 
judgment  the  setting  up  of  the  deferred  charge,  and  its 
consequent  inclusion  as  an  asset,  is  justified  by  its  probable 
value  to  the  future  business. 

But  it  is  not  enough  that  the  expenditure  has  been 
made.  For  instance,  a  large  number  of  circular  letters 
calling  attention  to  a  special  sale  in  January  may  be  sent 
out  in  December.  If  the  auditor  commences  work  in 
February  and  finds  that  the  campaign  was  a  total  failure, 
it  would  be  rather  misleading  for  him  to  certify  to  the 
accuracy  of  a  balance  sheet  as  of  December  31  showing 
the  entire  expenditure  as  an  asset. 

An  auditor  should  be  willing  to  back  up  his  opinion 
by  his  certificate.  If  in  his  opinion  expenditures  of  this 
nature  are  actually  deferred  assets,  he  should  so  certify. 
It  should,  however,  be  noted  that  the  most  successful 
concerns  carry  on  selling  campaigns  all  the  time,  and  there 
must  be  some  limit  to  the  postponement  of  the  actual 
charges  to  current  operating. 

In  the  discussion  of  a  paper  presented  at  the 
1908  meeting  of  the  American  Association  of  Public 
Accountants,  in  which  the  matter  of  deferred  charges  was 
mentioned,  George  O.  May,  C.P.A.,  said: 


THE    DETAILED    AUDIT  347 

A  further  point  raised  by  one  of  the  speakers  was  as  to  the  carrying 
forward  of  expenses  on  seasonal  business.  I  think  this  is  a  dangerous 
practice,  especially  where  there  is  a  big  asset  of  good-will.  I  think  the 
more  conservative  view  to  take  is  that  the  expenses  necessary  to  keep 
up  the  next  season's  business  are  effectively  an  expense  for  preserving 
the  good-will  of  the  business.  As  regards  the  buying  expenses  of  a 
department  store,  I  do  not  think  any  valid  objection  can  be  taken  to 
these  being  included.  In  my  experience  it  has  often  been  found,  in 
fact  generally,  that  department  stores  do  not  take  into  account  discounts 
on  purchases  on  the  one  hand,  or  buying  expenses  on  the  other,  and 
that  these  about  offset  each  other. 

If  the  business  is  not  successful  there  will  be  no  future 
profits  to  which  the  deferred  items  can  be  charged. 
Therefore,  the  auditor  should  use  every  argument  he  can 
muster  to  induce  his  client  to  absorb  these  expenses  as 
soon  as  possible,  and  never  carry  them  forward  unless  it 
would  be  improper,  from  every  point  of  view,  to  include 
them  among  the  current  expenses. 

More  than  one  enterprise  has  been  wrecked  by  the 
failure  to  look  preliminary  or  establishment  expenses 
squarely  in  the  face.  The  temptation  to  state  the  current 
operations  in  such  a  way  as  to  show  a  profit  has  been  too 
strong,  and  so  they  have  gone  along  from  year  to  year, 
the  burden  increasing  instead  of  diminishing,  with  an 
inevitable  day  of  reckoning  when  it  is  realized  that 
liabilities  cannot  be  liquidated  with  capitalized  expenses. 

The  recent  report  of  an  automobile  business  stated 
that  the  auditors  had  insisted  on  charging  off  all  of  the 
expenses  of  establishing  branches  which  previously  had 
been  carried  as  an  asset.  The  monthly  reports  had  shown 
big  profits,  which  had  been  largely  paid  out  in  dividends, 
with  the  result  that  the  working  capital  had  been  reduced 
to  an  amount  below  the  safety  fine. 

If  auditors  with  the  courage  of  their  convictions  had 
been  consulted  earlier  the  company's  credit  would  probably 
not  have  been  impaired  to  the  extent  it  was. 


348 


AUDITING 


Extraordinary  expenditures,  such  as  repairs  and 
renewals  incident  to  accidents  or  storms,  are  sometimes 
capitalized  at  the  time  with  the  expressed  intention  of 
spreading  the  loss  over  several  years.  The  same  situation 
arises  where  accident  insurance  is  not  carried,  a  certain 
percentage  of  the  gross  receipts  being  set  aside  to  a 
reserve  account  to  pay  losses,  and  the  payments  being  in 
excess  of  the  reserve.  Quite  frequently  the  debit  balances 
so  created  are  carried  forward  as  an  asset  until  subsequent 
accruals  wipe  out  the  deficit. 

This  practice  is  not  sound,  because  in  the  last  analysis 
it  simply  results  in  setting  up  on  the  balance  sheet 
accounts  which  are  in  no  sense  of  the  word  assets.  If  the 
word  ''assets"  means  anything  at  all,  there  can  be  no 
justification  for  the  inclusion  of  items  of  maintenance, 
expended  because  of  necessity,  and  which  do  not' tend  to 
improve  the  physical  or  financial  position  of  the 
enterprise. 

It  may  be  that  these  charges,  if  incorporated  among 
the  costs  and  expenses  of  a  current  period,  tend  to  hide 
the  normal  operations,  but  if  the  unusual  item  is  clearly 
set  forth  this  procedure  is  preferable  to  making  direct 
charges  to  surplus.  It  may  be  hard  to  resist  the  tempta- 
tion, but  the  practice  is  to  be  condemned.  It  may  not 
sound  well  or  look  well,  but  it  has  the  advantage  of 
portraying  the  actual  state  of  affairs,  which  is  not  the  case 
when  an  attempt  is  made  to  designate  an  expense  account 
as  an  asset.  Directors  who  realize  their  personal  responsi- 
bility for  dividends  paid  out  of  capital  will  not  vote  for  a 
distribution  of  earnings  which  does  not  take  into  account 
expenses  actually  incurred. 

All  payments  for  insurance,  bank  discount,  rent,  taxes, 
dues,  subscriptions,  and  similar  items  should  be  scrutin- 
ized in  order  to  determine  the  proportion,  if  any,  which 


THE    DETAILED    AUDIT 


349 


applies  to  a  subsequent  period  and  thus  constitutes  an 
asset  when  the  books  are  closed,  in  the  form  of  a  deferred 
charge  to  the  future  operations  of  the  business.  In  order 
to  save  the  auditor's  time  he  may  request  one  of  the 
client's  clerks  or  the  insurance  broker  to  calculate  the 
prepaid  items,  in  all  cases  testing  the  accuracy  of  their 
work. 

Where  discount  on  bonds  is  carried  as  a  deferred 
charge  to  operations,  the  auditor  should  verify  the  amorti- 
zation calculations.  If  this  provision  is  not  in  order,  an 
adjustment  should  be  made  before  the  balance  sheet  is 
certified  to. 

Legal  Expenses  and  "Graft" 

If  charges  to  legal  expenses  consisted  merely  of 
current  bills  from  attorneys,  no  special  mention  would  be 
necessary,  but  the  account  is  such  an  elastic  one  that  it 
requires  special  and  careful  attention. 

In  some  lines  of  business  secret  commissions  are  paid 
to  the  purchasing  agents  of  customers.  In  spite  of  the 
publicity  which  such  practices  have  received  during  the 
last  few  years,  "graft"  still  exists  and  no  doubt  will 
flourish  for  years  to  come.  Where  the  recipients  are 
unusually  sensitive  it  is  customary  to  charge  the  amounts 
paid  to  legal  expenses  or  some  other  account  which  serves 
to  screen  the  true  purpose  of  the  payments.  From  an 
accounting  point  of  view  this  is,  of  course,  highly  objec- 
tionable, because  it  permits  sales  to  go  through  with 
what  are  almost  invariably  excessive  gross  profits  without 
the  chance  of  charging  against  such  sales  one  of  the  direct 
expenses  connected  therewith.  Legal  expense  is  not 
usually  regarded  as  one  of  the  items  of  selling  costs,  and 
the  auditor  who  suspects  the  truth  can  hardly  restate  the 
accounts  to  accord  with  his  suspicion.     The  vouchers  for 


^^O  AUDITING 

such  payments  will  be  signed  by  some  responsible  officer 
of  the  corporation  or  a  member  of  the  firm,  so  that  the 
honesty  of  the  disposition  of  the  funds  can  hardly  be 
questioned. 

Some  years  ago  an  auditor  of  high  standing  discovered 
in  the  audit  of  one  business  that  a  commission  had  been 
paid  to  the  superintendent  of  the  plant  owned  by  another 
client.  He  informed  the  latter,  but  was  not  profusely 
thanked  for  his  information.  The  other  corporation 
learned  of  the  fact,  called  it  a  gross  breach  of  trust,  and 
declined  to  pay  the  auditor's  bill. 

If  an  auditor  feels  that  the  morals  of  his  client  are  to 
be  judged  along  with  the  accounts,  he  should  have  the 
courage  of  his  convictions  and*  so  inform  the  client  before 
the  work  is  started.  He  will  not  then  have  to  charge  off 
his  bill  to  bad  debts. 

Repairs  and  Renewals 

In  the  audit  of  a  large  manufacturing  establishment 
this  will  be  the  most  troublesome  account  upon  which 
the  auditor  will  be 'called  to  pass. 

The  underlying  purpose  of  the  audit  of  expenses  is  to 
ascertain  as  far  as  possible  that  an  equivalent  was  received 
for  the  liability  assumed,  but  the  improper  application  in 
the  books  of  the  expenditure  for  repairs  and  maintenance 
may  upset  the  accuracy  of  a  balance  sheet  in  spite  of  the 
fact  that  value  was  received  for  the  liability  assumed. 
That  is,  the  expenditure  for  repairs  or  for  renewals  may 
be  charged  to  plant  or  some  other  asset  account  instead 
of  to  current  operating  expense,  thus  inflating  the  assets 
on  one  hand  and  the  profits  on  the  other.  It  must  be 
kept  in  mind  constantly  that  tacit  conspiracy  usually 
exists  to  bring  about  this  very  result,  and  the  auditor  will 
be    apt    to    find    strong    forces    arrayed    against    him    as 


THE    DETAILED    AUDIT 


351 


soon  as  an  accurate  accounting  for  maintenance  items  is 
begun. 

In  some  plants  the  necessity  for  repairs  and  renewals 
is  so  constant  that  the  aggregate  cost  appears  at  about 
the  same  figure  from  year  to  year.  In  other  plants  the 
item  is  a  fluctuating  one.  In  the  latter  case  there  would 
be  no  objection  to  setting  aside  a  fixed  annual  sum  based 
on  the  average  over  a  period  of  years,  and  charging 
against  the  account  the  actual  expenditures  for  repairs 
and  renewals. 

Care  should  be  taken  in  establishing  such  a  policy,  to 
commence  it  when  repairs  are  under  the  average.  The 
balance  unexpended  at  the  end  of  the  first  year  would  be 
carried  over  as  a  reserve,  and  at  no  time  should  the 
accourtt  show  a  debit  balance  or  be  carried  as  a  deferred 
asset.  If  the  account  shows  a  debit  at  any  time,  the  debit 
should  be  transferred  to  profit  and  loss,  or  the  reserve 
increased. 

The  ordinary  manager,  superintendent,  or  foreman 
seems  to  feel  that  it  is  a  reflection  on  him  individually  or 
on  his  department  to  incur  any  considerable  expense  on 
renewals  and  repairs  which  he  knows  will  increase  his  cost 
of  operating.  He  knows  that  an  item  charged  to  an  asset 
account  will  not  be  charged  against  him,  so  it  is  no  wonder 
that  an  analysis  of  plant  accounts  sometimes  discloses  re- 
markable items  which  are  in  no  sense  of  the  word  better- 
ments, but  current  maintenance. 

In  order  to  make  a  complete  audit  of  items  which 
should  be  charged  to  repairs,  the  charges  to  plant 
accounts  must  be  analyzed. 

Allowances  and  Returns 

There  are  two  very  good  reasons  for  a  careful  scrutiny 
of  all  credits  to  customers,  the  first  beine  that  by  means 


352 


AUDITING 


of  unauthorized  credits  fraud  may  be  concealed.  That  is, 
cash  collected  from  a  customer  is  not  accounted  for,  and 
subsequently,  to  avoid  discovery,  the  ledger  account  is 
closed  by  an  entry  which  indicates  that  goods  have  been 
returned  or  that  an  allowance  has  been  made. 

The  second  reason  is  that  in  the  absence  of  fraud  there 
may  be  carelessness  both  in  the  manner  of  granting  credit 
for  allowances  and  returns  and  in  the  record  thereof.  For 
instance,  some  automobile  dealers  deduct  freight  from 
credits  for  returned  defective  parts;  others  do  not.  To  a 
dealer  doing  a  large  business  this  makes  a  difference  of 
several  hundred  dollars  a  year. 

In  some  concerns  full  credit  is  not  given  where  goods 
are  returned  simply,  on  account  of  an  overstock.  In 
others,  there  is  little  or  no  check  on  the  returns  and  full 
credit  is  allowed. 

The  auditor  should,  therefore,  examine  the  record 
which  has  been  kept  and  see  to  it  that  so  far  as  possible 
the  entries  are  approved  by  some  responsible  official  and 
that  no  abuse  has  been  made  of  the  return  privilege.  In 
order  to  test  the  integrity  of  the  entries,  it  may  be  desir- 
able to  call  for  the  correspondence  in  connection  with  a 
certain  number  of  items. 

Goods  returned  are  not  purchases,  but  deductions 
from  sales,  but  so  far  as  stock  records  are  concerned  they 
should  be  treated  as  purchases  and  tests  should  be  made 
to  see  that  the  entries  in  the  return  book  are  posted  to 
the  stock  sheets  as  regularly  as  those  in  the  purchase 
records.  Otherwise  an  opportunity  might  be  afforded  to 
a  stock  clerk  to  ship  goods  without  accounting  therefor. 

Separate  columns  should  be  kept  in  the  allowance  and 
return  book,  as  allowances  may  or  may  not  be  posted  to 
a  separate  ledger  account,  while  returns  are  always 
deductible  from  sales. 


THE     DETAILED    AUDIT 


353 


The  newspapers  recently  reported  a  case  wherein  it 
appeared  that  the  bookkeeper  of  a  baking  company  had 
manipulated  his  books  by  crediting  customers  with  exces- 
sive returns.    The  following  is  the  police  account,  in  part: 

He  (bookkeeper)  left  the  firm  the  early  part  of  this  month,  and 
when  his  books  were  examined,  the  firm  found  a  shortage  of  more  than 
$1,500.  He  admitted  entering  in  the  books  to  the  credit  of  customers  a 
greater  number  of  loaves  of  bread  daily  than  were  actually  returned  by 
the  firm's  drivers. 

Empties 

In  many  lines  of  business  shipments  are  made  in 
bottles,  boxes,  barrels,  or  other  form  of  container,  which 
have  a  residual  value,  the  test  of  the  latter  being  the  cost, 
durability,  and  expense  of  return.  When  no  charge  is 
made  for  the  container  and  credit  is  allowed  for  returns, 
there  is  the  equivalent  of  a  purchase,  provided  the  allow- 
ance is  not  more  than  the  open  market  price.  If  the 
credit  is  at  a  higher  price  than  the  market,  the  excess  is 
clearly  a  deduction  from  sales.  If  credit  is  passed  only 
upon  return  and  the  allowance  is  not  more  than  cost,  no 
record  need  be  kept  of  those  outstanding,  as  it  makes  no 
difference  whether  or  not  they  are  returned.  If  a  separate 
charge  for  containers  appears  on  the  invoices,  there  is  no 
difificulty  in  keeping  track  of  the  aggregate  charged  for 
and  the  aggregate  returned,  if  the  information  is  of  value. 

In  the  case  of  kegs,  crates,  syphons,  etc.,  for  which  no 
charge  is  made,  but  which  must  be  returned,  the  most 
common,  and  probably  the  most  satisfactory,  method  of 
handling  is  to  note  the  quantities  in  the  sales  book  and 
post  the  items  to  the  customers  ledger,  in  which  a  special 
column  should  be  provided  on  both  debit  and  credit  sides. 
If  this  system  has  not  been  in  force,  a  very  careful  test  of 
the  records  should  be  made,  as  errors  usually  exist,  and 
they  may  be  unnecessary  as  well  as  expensive. 


354  AUDITING 

The  method  of  inspection  and  of  passing  credit  should 
have  the  auditor's  attention.  If  the  receiving  clerk  is 
careless  or  inefficient,  the  number  of  containers  returned 
may  not  be  verified  and  damaged  or  broken  containers  may 
be  passed  as  in  good  condition.  The  clerk  in  charge  of 
the  credits  should  not  be  allowed  to  settle  the  custom  of 
the  house  with  respect  to  prices  to  be  allowed,  freight 
payments,  etc. 

If  containers  are  charged  to  customers  at  a  substantial 
increase  over  cost,  and  if  permission  is  granted  for  return 
at  the  same  price,  the  auditor  must  provide  a  reserve  to 
cover  outstandings  when  the  books  are  closed. 

Where  containers  are  furnished  free  with  an  obligation 
to  return,  it  must  be  assumed  that  customers  treat  the 
obligation  lightly  and  that  a  considerable  proportion  will 
not  be  accounted  for,  in  addition  to  the  usual  losses  and 
breakages.  If  feasible,  an  attempt  should  be  made  at 
some  convenient  time  to  secure  an  actual  inventory  of 
containers  on  hand  and  within  reach  that  are  positively 
known  to  be  recoverable.  A  comparison  of  these  figures 
with  the  inventory  would  form  a  sound  basis  for  a 
depreciation  or  expense  rate. 

Salaries 

In  all  cases  a  pay-roll  book  showing  names,  positions, 
and  salary  rates  of  all  employees  should  be  kept.  This  does 
not  include  workmen  and  others  whose  compensation  is 
referred  to  throughout  this  book  as  wages. 

The  book  should  be  arranged  with  thirteen  columns, 
to  cover  three  months'  time.  Each  column  should  be 
initialed  by  an  executive.  The  cashier  should  have  written 
authority  for  each  change  in  rate  and  for  each  name 
added.  If  one  cheque  is  drawn  for  an  entire  pay-roll,  the 
auditor  should  verify  the  footings  of,  say,  every  third  week. 


THE    DETAILED    AUDIT 


355 


Employees'  Bonds 

In  considering  the  question  of  relations  to  employees, 
the  auditor  should  always  include  in  his  audit  program 
the  query:  ''Are  all  employees  who  handle  funds  under 
surety  bonds?"  If  not,  they  should  be.  Some  employers 
arc  lax  in  this  respect,  others  will  not  incur  the  expense, 
and  a  fairly  large  class  dislike  to  mention  the  matter  to 
employees  who  have  occupied  positions  of  trust  for  a 
number  of  years. 

The  auditor  should  present  the  importance  of  such 
protection  and  point  out  that  the  expense  is  compara- 
tively small,  but  that  the  risk  is  not  an  imaginary  one. 
Of  course  the  auditor  has  performed  his  full  duty  after  his 
recommendation  has  been  considered,  and  if  nothing  is 
done  he  cannot  be  blamed  for  subsequent  loss. 

It  may  be,  however,  that  the  matter  should  have  con- 
sideration at  each  audit  as  conditions  and  employees 
change.  It  might  not  be  difficult  to  persuade  an  employer 
to  adopt  a  rule  that  every  new  employee  should  furnish  a 
bond  at  the  time  of  employment.  This  would  mean  that 
in  time  the  entire  staff  would  be  bonded.  In  every  case 
the  employer  should  pay  the  premium. 

Many  employers  find  it  valuable  to  insist  on  practically 
their  entire  force,  including  salesmen,  furnishing  a  surety 
bond.  The  reason  given  is  that  all  of  them  handle  funds 
at  one  time  or  another.  It  makes  it  easier  to  demand 
bonds  from  cashiers  when  the  rule  is  general,  and  a  lower 
rate  can  be  secured  where  several  persons  are  covered  by 
one  bond.  The  chief  value,  however,  in  requiring  bonds 
from  salesmen  is  that  the  employer  is  assured  that  a  most 
exhaustive  inquiry  is  made  into  each  applicant's  character 
and  reputation,  extending  back  over  a  considerable  period 
of  years.  This  search  is  far  more  extensive  than  an 
employer  can,  or  cares  to,  make  himself,  and  as  such  a 


356 


AUDITING 


bond  for,  say,  $500  does  not  cost  more  than  $2  or  $3,  it 
is  well  worth  a  trial.  Salesmen  are  usually  intrusted  with 
a  traveling  expense  advance,  and  similar  funds  are  placed 
at  the  disposal  of  other  employees. 

Failure  to  secure  a  bond  should  be  considered  a  prima 
facie  reason  for  non-employment,  or  dismissal,  and  a  good 
reason  must  be  furnished  to  offset  the  effect  of  the  refusal 
of  the  surety  company. 

It  is  obvious  that  a  man  who  cannot  furnish  a  $500 
surety  company  bond  is  not  a  desirable  clerk. 

Employers  sometimes  think  that  placing  an  employee 
under  bond  in  some  way  obviates  the  necessity  for  an 
audit.  As  a  matter  of  fact,  this  precaution  is  all  the  more 
advisable  in  that  a  means  is  provided  for  recouping  the 
amount  misappropriated,  if  a  defalcation  does  occur.  The 
surety  companies  themselves  advocate  periodical  audits. 
One  of  the  leading  bonding  companies  in  America,  says: 

Frequent,  regular,  and  thorough  audits  of  cash  and  books  of 
account  by  certified  public  accountants  are  unquestionably  of  the  great- 
est benefit  to  the  business  man  and  institution,  and  should  be  universally 
adopted. 

We  cannot  put  what  we  state  above  too  emphatically,  and  it  is  de- 
serving of  the  serious  consideration  of  every  business  man. 

The  surety  companies  frequently  quote  their  minimum 
rates  where  they  find  that  the  books  are  regularly  audited 
by  professional  auditors  in  whom  they  have  confidence, 
and  this  may  represent  a  considerable  saving  to  the 
assured. 

Save  or  quit!  Another  point  in  connection  with  the 
relation  between  employer  and  employed  is  that  of  the 
financial  condition  of  the  clerk  who  handles  or  has  access 
to  funds  or  personal  property  of  value.  Defalcations  are 
usually  preceded  by  living  beyond  one's  means,  and  this 
fact  is  frequently  known  to  an  employer.    There  are  many 


THE    DETAILED    AUDIT  ^57 

legitimate  and  deserving  cases  where  clerks  find  them- 
selves in  debt.  If  honest,  they  will  endeavor  to  get  out 
of  debt  by  reducing  their  expenses.  In  any  event  there 
is  a  loss  in  efficiency  wherever  a  clerk  is  living  beyond  his 
means.  It  must  be  on  his  mind  to  the  detriment  of  his 
work.  The  employer  who  permits  his  clerks  to  overdraw 
their  salaries,  or  who  is  indifferent  to  evidences  of  extrava- 
gance, will  surely  suffer  in  the  end,  and  it  is  not  out  of 
place  for  an  auditor  to  remind  him  that  the  case  of  any 
employee  who  is  not  saving  money  requires  attention. 

The  author  has  known  of  cases  where  one  man, 
holding  a  responsible  position  in  an  office,  failed  in  his 
own  duty  and  was  the  cause  of  his  subordinates  failing  in 
theirs,  because  he  was  living  beyond  his  means  and  his 
financial  difficulties  worried  him  and  made  him  inefficient. 
It  would  have  been  cheaper  to  pay  him  his  full  salary  to 
stay  away  from  the  office. 

Salesmen's  Commissions 

Examine  contracts  and  note  provisions  as  to  percent- 
age, territory,  and  particularly  as  to  whether  commis- 
sions are  payable  on  delivery  of  goods  or  on  collec- 
tion of  accounts;  also  whether  based  on  gross  sales  or  on 
net  proceeds  after  deductions  for  cash  discounts,  freight, 
etc. 

Traveling  Expenses,  Entertaining,  etc. 

Examine  contracts  of  salesmen,  if  any,  to  see  if  limit 
has  been  placed  on  traveling  and  other  expenses.  If 
contracts  are  not  required,  inquire  of  manager  if  any 
understanding  of  this  nature  is  in  force. 

In  many  concerns  the  utmost  liberality  prevails  in 
such  allowances,  but  sentiment  along  these  lines  is 
changing    and    salesrnen    are    being    held    tg    a    stricter 


358 


AUDITING 


accountability  than  was  formerly  the  case.  The  auditor, 
therefore,  should  take  pains  to  make  inquiries  on  this 
point  at  each  audit. 

Vouchers  for  traveling  and  similar  expenses  should  be 
approved  by  some  one  in  authority. 

A  railroad  employee  whose  duty  it  was  to  prepare  the 
vouchers  for  traveling  expenses  was  recently  convicted  of 
padding  the  expense  accounts  of  officers  of  the  road.  By 
clever  duplication  of  half  a  dozen  signatures,  fictitious 
vouchers  covering  fictitious  expense  accounts  were 
prepared.  These  were  then  presented,  approved,  and  the 
amounts  collected.  When  arrested,  the  employee  com- 
plained that  the  railroad  paid  him  only  $100  a  month, 
although  his  predecessor  had  received  $175.  His  thefts 
aggregated  about  $5,000  over  a  period  of  two  or  three 
years. 

The  auditor  is  interested  in  seeing  that  railroad 
mileage  is  properly  accounted  for.  Mileage  may  be 
carried  as  a  separate  account  on  the  ledger,  if  it  is  large, 
or  it  may  be  regarded  as  cash  and  included  in  the  cash 
figures. 

When  it  is  given  out,  the  full  amount  in  the  book  is 
charged  at  cost  against  the  Traveling  Advance  account  of 
the  one  who  is  using  it.  When  it  is  returned,  credit  is 
given  just  as  if  cash  were  received. 

Wages 

In  the  audit  of  a  business  where  many  employees  are 
found  it  will  be  necessary  to  devote  some  time  to  a  con- 
sideration of  the  system  in  force,  with  respect  to  time 
records  and  wages  payments.  It  is  a  well-known  fact  that 
receipts  are  worthless  so  far  as  being  a  check  on  the 
amount  paid.  It  may  be  valuable  to  a  concern  to  have  a 
receipt    from   each   man   to   guard   against    subsequent 


THE     DETAILED    AUDIT  359 

disputes,  but  these  receipts  are  of  little  real  value  to  an 
auditor  who  is  attempting  to  prove  to  his  own  satisfaction 
that  the  aggregate  amounts  of  the  pay-roll  payments  have 
reached  the  hands  of  those  entitled  thereto.  The  auditor 
must  think  this  out  for  himself  in  each  audit,  but  it  is 
suggested  that  the  best  check  on  wages  payments  is  to 
use  as  many  people  as  possible  during  the  various  stages 
from  the  point  where  the  time  is  recorded  to  the  final 
handing  out  of  the  envelopes.  If  the  latter,  for  instance, 
is  done  by  an  employee  who  has  no  access  to  the  rolls  or 
to  the  cash,  it  makes  a  good  check.  If  an  auditor  is  on 
hand  when  the  men  are  being  paid  ofif,  he  should  supervise 
the  operation  or  take  a  more  active  part,  if  feasible. 
Obviously,  this  procedure  would  be  of  no  value  unless  it 
was  done  without  notice  to  anyone. 

A  few  large  corporations  have  tried  the  experiment  of 
paying  exclusively  by  cheque,  but  it  is  believed  that  the 
plan  has  been  abandoned  by  most  of  them. 

The  auditor  must  direct  his  attention  to  two  main 
points,  viz.,  the  records  which  may  be  kept  accurately,  or 
inaccurately,  and  the  clerical  force  in  charge  of  the 
records,  who  may  be  honest  or  dishonest. 

Fortunately  for  employers,  most  of  the  records  now  in 
general  use  are,  or  should  be,  mechanical  or  automatic. 
The  time  clock  registers  the  time  in  and  out,  and  other 
devices  stamp  the  time  actually  employed  on  various  jobs. 
In  the  office  these  records  in  turn  are  checked  and  proved 
by  mechanical  means. 

The  audit  of  wages  earned  therefore  resolves  itself  into 
a  critical  inspection  of  the  system  in  use.  Before  making 
this  inspection,  the  auditor  should  acquaint  himself  with 
the  particulars  of  all  the  latest  devices  on  the  market. 
He  can  then  evince  a  familiarity  with  any  system  he  finds 
and  note  any  lack  of  efficiency,  and  is  also  in  a  better 


36o 


AUDITING 


position  to  make  suggestions  where  unsatisfactory  methods 
are  found. 

The  author  feels  that  the  scope  of  this  book  is  too 
limited  to  contain  directions  as  to  the  best  system,  except 
to  suggest  that,  since  scientific  management  has  taken 
hold  of  the  labor  question  so  seriously,  and  has  been  more 
or  less  successful,  the  auditor  who  has  to  deal  with  the 
audit  of  wages  paid,  and  who  is  expected  to  criticize  the 
records  relating  thereto,  owes  to  himself  and  his 
profession  the  duty  of  at  least  reading  the  best-known 
books  on  factory  management,  and  glancing  over  the 
descriptive  circulars  of  some  of  the  really  wonderful 
mechanical  appliances  designed  especially  by  experts 
familiar  with  the  practical  side  of  the  question.  So  much 
for  the  system. 

The  personnel  and  extent  of  the  clerical  force  are 
important  from  the  auditor's  point  of  view.  He  should 
be  especially  vigilant  in  small  establishments  where  the 
office  force  is  small  and  where  the  same  clerk  keeps  or 
assists  with  the  original  records,  makes  up  or  assists  with 
the  envelopes,  and  distributes  them  or  has  some  connec- 
tion with  the  distribution  thereof. 

Concrete  instances  may  serve  better  than  theory  in 
pointing  out  the  course  the  auditor  should  take  to  satisfy 
himself  that  the  pay-rolls  are  correct. 

The  auditor  should  ascertain  that  the  names  of  dis- 
charged men  are  removed  from  the  pay-roll  as  of  the 
proper  date.  In  a  large  factory  the  foreman  handed  in  to 
a  clerk  in  the  office  who  had  access  to  the  pay-rolls,  slips 
bearing  the  names  of  men  discharged.  He  destroyed  the 
slips  and  recorded  full  time  to  the  credit  of  the  men  dis- 
charged. In  paying  ofif  he  secured  the  envelopes  and 
retained  the  money,  The  fraud  was  not  discovered  for 
a  long  time. 


THE    DETAILED    AUDIT  361 

In  a  factory  where  time  books  were  kept  by  the  fore- 
man, the  assistant  cashier  transferred  the  time  therein  to 
the  pay-roll  book.  In  addition,  he  entered  several  ficti- 
tious names.  The  cashier  himself  made  up  the  envelopes 
and  superintended  the  paying  off.  Each  week  a  number 
of  envelopes  were  left  over,  as  is  nearly  always  the  case  in 
a  large  plant,  on  account  of  sickness,  etc.  Most  of  them 
are  called  for  within  a  short  time.  In  this  case  the  dis- 
honest clerk  always  had  an  opportunity  to  secure  the  en- 
velopes covering  the  fictitious  names.  The  fraud  was  dis- 
covered by  the  auditor  calling  in  the  time  books  and  com- 
paring them  with  the  pay-roll. 

Duties 

The  vouching  of  duties  is  one  requiring  great  care, 
because,  until  recently,  collectors  of  internal  revenue 
would  not  accept  cheques  in  payment,  but  insisted  on 
legal  tender.  Where  such  payments  are  few  in  number, 
they  are  usually  made  through  a  custom-house  broker,  and 
his  invoices,  if  properly  checked  and  approved,  will  be 
sufficient  evidence  of  the  propriety  of  the  payments. 

In  any  event,  the  auditor  should  inquire  into  the  pro- 
cedure in  force  and  satisfy  himself  that  the  matter  is  prop- 
erly handled.  Instances  have  been  known  where  every- 
thing was  left  to  clerks  who  did  not  have  skill  enough  to 
discover  errors  if  they  did  exist. 

Interest  and  Collection  Charges 

Too  much  confidence  is  placed  in  the  accuracy  of  bank 
clerks;  therefore  it  will  usually  be  found  that  interest 
charged  on  loans  and  credited  on  balances,  discount  de- 
ducted, and  collection  fees  charged  are,  in  nine  cases  out 
of  ten,  accepted  as  final  without  being  checked  by  the 
client's  staff.    Auditors  whose  experience  includes  much 


362 


AUDITING 


bank  work  are  familiar  with  the  numerous  errors  made 
by  bank  clerks  in  their  own  records,  and  while  perhaps  a 
majority  of  bank  officers  insist  on  these  errors  being  lo- 
cated and  corrected,  yet  it  is  obvious  that  in  calculations 
involving  interest  and  collection  charges  or  credits,  there 
is  not  the  same  likelihood  of  correction  of  errors  as  exists 
with  those  items  which  enter  into  the  regular  double- 
entry  system  of  the  bank. 

It  follows  that  many  errors  will  be  made  and  will 
remain  undetected  unless  the  auditor  tests  the  items.  But 
the  auditor  should  not  stop  with  the  verification  of  the 
calculations.  Banks  will  charge  as  high  an  interest  rate 
on  loans  and  discounts  as  they  think  the  traffic  will  bear, 
and  if  an  auditor  finds  that  a  concern  with  first-class  credit 
is  being  charged  6  per  cent,  when  he  knows  that  other 
concerns  of  equal  or  inferior  standing  are  paying  4%  or 
5  per  cent,  it  will  certainly  be  in  order  to  mention  the 
matter  when  a  good  opportunity  arises.  The  successful 
auditor  will  not  lose  any  good  chance  to  render  a  service 
which  falls  within  the  scope  of  a  business  adviser. 

Insurance  Premiums 

Experience  shows  that  the  bills  of  insurance  agents 
are  rarely  scrutinized  unless  the  item  of  premiums  is  a 
very  large  one  and  the  bill  is  in  charge  of  some  one 
especially  designated  to  keep  track  of  the  insurance  in 
force  and  the  rates  charged  for  insurance.  For  this  reason 
a  careful  audit  of  the  premium  bills  and  a  careful  analysis 
of  the  total  insurance  carried  is  a  fruitful  field  of  inquiry 
for  the  auditor,  and  particularly  advisable  in  audits  where 
great  care  is  taken  with  other  classes  of  expenses. 

In  one  case  an  auditor  noticed  that  a  policy  had  been 
canceled  and  another  company  substituted.  He  looked 
for  a  credit  to  cover  the  return  premium  on  the  canceled 


THE    DETAILED    AUDIT  363 

policy,  but  failed  to  find  it.  This  started  a  complete 
investigation  into  insurance  matters,  and  it  was  found  that 
for  several  years  back  one  or  more  policies  had  been 
canceled  each  month,  due  to  the  undesirability  of  the  risk, 
but  that  no  credit  therefor  had  been  issued  by  the  agent. 
The  total  amount  recovered  amounted  to  several  hundred 
dollars  and  the  discovery  greatly  enhanced  the  auditor's 
reputation. 

Sufficient  attention  is  not  paid  to  the  amount  of  insur- 
ance carried.  If  overinsured,  a  useless  expense  is  incurred, 
and  if  underinsured,  an  unjustifiable  risk  is  assumed.  The 
matter  is  one  requiring  comparatively  little  time,  perhaps 
not  so  much  as  to  verify  the  footings  or  postings  for  a 
short  period,  and  is  of  very  much  more  importance. 

As  stated  elsewhere,  the  unexpired  portion  of  pre- 
miums prepaid  at  the  date  of  the  balance  sheet  is  a  de- 
ferred asset.  In  a  going  business  it  is  proper  to  set  up 
the  full  unexpired  proportion  of  the  premiums  paid  in 
advance,  but  in  a  statement  of  afifairs,  such  as  is  required 
in  the  event  of  proposed  or  forced  liquidation,  it  may  be 
necessary  to  base  the  calculations  upon  the  ''short"  rates 
which  are  used  in  the  cancellation  of  policies. 

Freight  and  Express 

Freight  is  another  class  of  expense  which  is  passed 
by  many  auditors  on  the  assumption  that  the  amounts 
paid  are  sure  to  be  accurate,  and  that  it  is  a  waste  of  time 
to  attempt  to  go  into  detail.  As  a  matter  of  fact,  trans- 
portation companies,  and  particularly  express  companies, 
are  chronic  overchargers,  and  every  bill  must  be  checked 
most  carefully. 

An  auditor  need  not  go  into  tariff  details^  but  he 
should  inquire  closely  into  the  method  of  check  in  use, 
and  if  he  finds  that  the  freight  and  express  bills  are  not 


3^4 


AUDITING 


approved  as  to  weights  and  rates  by  an  intelligent  clerk 
who  uses  all  possible  sources  of  information  to  secure  the 
lowest  quotations,  he  will  probably  find  an  opportunity 
to  make  a  constructive  report  on  the  situation. 

Many  trades  have  a  central  association  with  a  traf^c 
bureau,  which  furnishes  full  and  free  information  when 
requested  to  do  so  by  its  members.  The  Interstate  Com- 
merce Commission  will  also  assist  a  shipper  who  feels 
aggrieved. 

In  one  very  large  manufacturing  company  being 
audited  for  the  first  time  by  the  author's  firm,  it  was  found 
that  practically  no  attention  was  given  to  the  inspection 
of  freight  bills,  it  being  assumed  that  the  charges  were 
always  in  order.  A  careful  test  disclosed  the  fact  that 
many  purchases  had  been  made  on  a  basis  of  freight  being 
prepaid  by  the  shipper.  Now  it  is  the  custom  in  such 
cases  for  the  consignee  to  pay  the  freight  and  deduct 
same  from  the  invoices.  The  company  under  audit  had 
paid  the  freight  in  every  case,  but  had  charged  it  to  pur- 
chases account  instead  of  to  the  shipper.  The  investiga- 
tion was  carried  back  several  years  and  many  thousands 
of  dollars  were  actually  recovered. 

Postage 

Vouchers  should  be  secured  for  all  purchases  of  stamps. 
Postmasters  will  always  sign  receipts  when  requested 
to  do  so. 

Defalcations  of  small  sums  are  frequently  found  in  con- 
nection with  postage  accounts,  so  that  an  auditor  should 
not  only  scrutinize  such  payments  very  carefully,  but 
should  suggest  safeguards  which  will  reduce  future  possi- 
bilities of  loss,  and  more  important  still,  remove  a  serious 
source  of  temptation  to  junior  clerks. 

There  should  be  some  relation  between  the  total  cost 


THE     DETAILED    AUDIT 


365 


of  postage  and  other  expense  accounts,  such  as  stationery 
and  printing,  advertising  circulars,  etc. 

Where  bills  are  rendered  for  dues,  subscriptions,  etc., 
it  is  important  to  note  that  they  may  be  mailed  for  one 
cent  instead  of  two.  The  post-office  regulation  is  that 
bills  entirely  in  print,  with  the  exception  of  the  names  of 
the  addressee  and  sender,  are  third-class  matter,  and  when 
sent  in  the  mails  unsealed,  are  chargeable  with  postage 
at  the  rate  of  one  cent  for  each  two  ounces  or  fraction 
thereof.  Bills  bearing  written  items,  amounts,  etc.,  are 
first-class  matter  and  chargeable  with  postage  at  the  rate 
of  two  cents  an  ounce  or  fraction  thereof. 

A  daily  mail  book  showing  the  total  postage  used  on 
outgoing  mail  requires  very  little  time  to  compile  and  is 
valuable  for  several  reasons.  It  affords  an  opportunity 
to  apportion  the  cost  to  various  accounts  and  has  a  most 
excellent  moral  effect  on  those  who  handle  the  stamps, 
as  some  one  in  authority  from  each  department  should 
initial  the  charges  to  such  department  at  least  weekly. 

Inquiry  should  be  made  to  ascertain  if  postage  is  paid 
on  outgoing  shipments  of  goods  in  small  quantities. 
Many  concerns  add  postage  to  such  shipments,  and  cus- 
tom permits  it  unless  quotations  are  made  ''prepaid."  If 
not  so  made  and  a  considerable  number  of  shipments  are 
made  by  mail,  it  will  be  in  order  for  the  auditor  to  suggest 
that  the  cost  of  the  postage  be  added  to  the  invoice. 

In  one  instance,  where  quotations  distinctly  stated 
that  postage  would  be  added  where  small  lots  were  sent 
by  mail,  the  shipping  department  was  extremely  careless 
and  few  such  charges  were  made.  The  auditor  who  dis- 
covered the  laxity  received  warm  commendation  for  his 
vigilance  and  was  requested  to  make  the  most  comprehen- 
sive investigation  into  all  the  other  departments  of  the 
business. 


366 


AUDITING 


Journal  Vouchers 

Vouchers  should  be  submitted  for  all  journal  entries 
and  the  auditor  need  not  announce  in  advance  how  many 
of  them  he  intends  to  inspect.  If  formal  vouchers  have 
not  been  taken,  the  journal  should  be  read  over  carefully 
and  all  entries  for  which  authority  should  have  been 
secured  pointed  out  as  requiring  proof. 

The  journal  can  be  used  fraudulently  by  fictitious  or 
irregular  credits  to  customers  or  other  personal  accounts 
to  conceal  the  misappropriation  of  cash  collected  there- 
from. To  detect  this,  all  credits  to  customers  for  allow- 
ances, returns,  etc.,  and  all  accounts  charged  off  as  bad 
should  be  approved  by  some  authorized  official.  If  no 
such  approval  appears,  the  auditor  should  ask  that  the 
journal  entries  themselves  be  initialed.  Other  credits  to 
personal  accounts  are  made  for  salesmen's  expenses,  etc. 
These  should  be  verified  in  the  same  manner  as  cash 
vouchers. 

Well-managed  concerns  now  supply  their  salesmen 
with  a  fixed  fund,  and  payments  for  expenses  cover  the 
exact  expenditures  during  a  given  period.  This  obviates 
the  necessity  for  paying  out  round  sums  after  the  first 
item.  Subsequent  payments  can  be  charged  direct  to  the 
proper  expense  account  and  journal  entries  are  done 
away  with. 

Transfers  from  one  account  to  another  may  be  for 
the  purpose  of  fraudulently  increasing  one  account  or 
decreasing  another. 

The  experienced  auditor  need  not  spend  very  much 
time  on  the  journal,  as  a  careful  glance  over  the  pages 
will  develop  any  entries  which  require  explanation.  The 
inexperienced  auditor  should  examine  the  entries  care- 
fully and  call  for  documentary  evidence  to  support  an 
item  which  by  any  chance  might  be  irregular. 


THE    DETAILED    AUDIT 


^^7 


There  is  a  tendency  on  the  part  of  bookkeepers  to 
use  a  printed  form  for  journal  vouchers  which  serves  in 
most  cases  as  a  memorandum  from  which  the  actual  book 
entry  is  made,  the  result  being  that  every  entry  is  dupli- 
cated. One,  however,  is  called  a  voucher,  although  it  may 
not  be  approved  nor  have  attached  any  evidence  of  its 
authenticity.  If  such  a  form  is  used,  any  papers  or  docu- 
ments relating  thereto,  such  as  original  correspondence 
from  attorneys  stating  that  an  account  is  worthless,  etc., 
should  be  attached.  Where  founded  on  the  action  of  a 
committee  or  board  of-  directors,  reference  should  be 
made  to  the  page  of  the  minute  book  where  recorded. 
If  reference  is  made  to  a  contract  or  agreement,  the 
file  or  location  of  the  original  document  should  be 
stated. 

Purchase  Returns 

It  is  no  part  of  the  normal  conduct  of  a  business  to 
return  goods  which  have  been  purchased  and  received. 
For  this  reason,  when  goods  are  returned  because  they 
are  defective  or  unsatisfactory,  or  because  they  were  not 
ordered,  etc.,  the  record  of  such  returns  is  not  always  a 
permanent  or  satisfactory  one. 

In  most  cases  dependence  is  placed  on  a  memorandum 
on  the  original  invoice,  and  if  made  before  the  invoice  is 
entered  on  the  books,  it  is  practically  sure  to  prevent 
payment.  But  sometimes  the  invoice  will  have  been  en- 
tered, and  if  care  is  not  taken,  the  account  will  be  paid 
in  due  course  without  making  any  deduction. 

The  best  preventive  is  to  have  a  good-sized  book 
labeled  plainly  ''Returned  Purchases,'^  in  which  shall  be 
entered  a  memorandum  covering  every  return.  This  book 
should  be  compared  with  the  purchase  books  regularly  to 
prevent  errors  in  payments. 


368 


AUDITING 


Cancellation  of  Vouchers 

Instances  are  known  where  dishonest  clerks  have  used 
old  vouchers  to  support  fictitious  duplicate  payments, 
altering  the  dates  thereof.  It  is  always  important  for  an 
auditor  to  mark  a  voucher  in  such  a  way  that  there  can 
be  no  possibility  of  its  being  presented  or  used  again. 

If  clients  insist  that  the  auditor  must  not  mark  or 
deface  the  vouchers,  it  will  be  difficult  to  guard  against 
their  being  presented  again,  with  a  change  of  date  for 
instance.  In  view  of  this  possibility  the  auditor  should 
scrutinize  the  vouchers  very  carefully  and  lay  aside  for 
special  investigation  any  which  bear  signs  of  alteration. 
Where  possible,  all  vouchers  for  the  period  under  audit 
should  be  retained  in  the  custody  of  the  auditor  until  all 
have  been  examined. 

If  vouchers  are  numbered  consecutively  and  the  auditor 
keeps  a  memorandum  of  the  serial  numbers  of  those 
examined,  subsequent  attempted  duplication  might  thus  be 
disclosed. 

The  best  method  of  cancellation  is  to  use  a  rubber 
stamp  bearing  the  name  of  the  auditor  and  the  initial  or 
number  of  the  clerk  in  charge  of  the  audit.  Some  audit- 
ors use  a  conductor's  punch. 

The  book  entries  should  be  marked  in  some  distinctive 
way  to  indicate  that  a  voucher  therefor  has  been  com- 
pared with  the  entry,  and  as  the  voucher  may  be  more 
or  less  incomplete,  it  is  wise  to  use  different  marks  or 
initials  to  indicate  the  kind  of  voucher  submitted. 

Each  auditor  should  select  his  own  marks.  It  is  advis- 
able to  change  them  from  time  to  time  as  the  client's 
clerks  become  familiar  with  the  marks,  as  well  as  the 
procedure  of  a  routine  audit. 


CHAPTER    XVII 

THE    DETAILED    AUDIT    (Continued) 


THE  TRIAL  BALANCE 

One  of  the  most  important  matters  in  any  audit  is 
the  verification  of  the  trial  balance.  By  this  is  not  meant 
the  routine  checking  of  the  ledger  footings  and  extrac- 
tion of  the  balances  merely  to  test  its  arithmetical  accu- 
racy, but  that  careful  examination  or  study  of  it  which 
will  throw  light  on  the  entire  and  detailed  working  of 
the  whole  system.  Every  ledger  caption  should  mean 
something.  After  some  experience,  an  auditor,  by  simply 
looking  at  the  various  accounts  scheduled  on  the  trial 
balance,  will  be  able  to  discuss  the  whole  system,  and 
without  further  data  suggest  improvements  therein.  Of 
course,  no  sane  practitioner  would  commit  himself  after 
such  a  cursory  glance,  but  he  will  have  gained  sufficient 
insight  into  the  affairs  of  his  client  to  suggest  the  next 
and  succeeding  steps  in  the  audit.  He  must  not  spend 
too  much  time  on  trifling  errors  in  a  trial  balance,  but 
should  take  enough  time  to  satisfy  himself  that  the  trial 
balance  honestly  represents  the  face  of  the  ledgers  and 
that  it  may  be  relied  on  as  a  basis  for  a  report  or  balance 
sheet. 

The  auditor  should  secure  a  copy  of  the  last  trial  bal- 
ance at  the  earliest  possible  moment.  Usually,  if  he  will 
ask  for  it  at  the  commencement  of  an  audit,  it  will  be 
copied  for  him  by  an  office  clerk.     He  need  not  ask  for 

369 


Z70 


AUDITING 


the  customers'  balances  in  detail,  as  he  will  wish  to  com- 
pile these  himself,  as  explained  hereafter.  As  to  the 
other  accounts,  however,  the  trial  balance  is  of  great  im- 
portance. Subsequent  analyses  of  accounts  will  lead  up 
to  the  trial  balance,  and  any  alteration  of  figures  in  the 
ledger  would  probably  be  disclosed  thereby. 

If  the  trial  balance  is  not  correct,  it  is  no  part  of  an 
auditor's  duties  to  locate  the  error  or  errors  therein.  He 
should  insist  on  the  client's  staff  securing  an  exact  bal- 
ance, or,  if  this  is  impracticable,  the  matter  should  be 
referred  to  the  client  and  an  understanding  reached  as 
to  further  procedure. 

The  best  plan  is  for  the  audit  to  proceed  as  if  no  differ- 
ence exists.  The  various  tests  suggested  should  be  made, 
but  no  more,  unless  numerous  errors  are  discovered,  in 
which  case  permission  should  be  secured  from  the  client 
to  verify  all  the  work  and  secure  a  correct  balance.  .Where 
the  errors  are  few  in  number  and  the  accounts  are  reason- 
ably correct,  the  auditor  should  not  attempt  to  hunt  for 
clerical  errors.  He  would  better  postpone  the  audit  until 
they  are  located,  even  if  an  additional  clerk  is  required. 
Anyone  who  spends  his  time  in  such  work  is  not,  and  is 
not  developing  into,  a  professional  auditor.  Such  ele- 
mentary bookkeeping  work  should  be  left  to  clerks. 

Outstanding  Accounts 

A  schedule  of  accounts  receivable  should  be  compiled 
as  part  of  the  trial  balance.  It  is  a  waste  of  time  to  pre- 
pare or  verify  a  trial  balance  and  subsequently  duplicate 
the  larger  part  of  it  in  the  form  of  customers'  balances. 

The  balance  due  from  each  customer  should  represent 
specific  invoices  unpaid,  or  else  it  should  be  clear  that  the 
debtor  is  making  partial  payments.  Where  the  credits 
indicate  that  the  latter  is  not  the  case,  yet  the  balance 


THE    DETAILED    AUDIT 


371 


due  cannot  be  identified  with  the  most  recent  invoices, 
then  it  is  apparent  that  a  discrepancy  exists  which  requires 
explanation.  In  all  such  cases  the  auditor  should  require 
one  of  the  office  staff  to  show  the  composition  of  the 
balance.  It  may  develop  that  in  order  to  furnish  this 
information  the  entire  account  will  have  to  be  analyzed, 
but  this,  of  course,  is  the  best  possible  reason  for  insist- 
ence on  the  part  of  the  auditor. 

Income  from  sales  cannot  be  completely  veriRed  until 
all  debits  to  customers  are  ascertained  to  be  collectable; 
charges  known  to  be  uncollectable,  but  remaining  open  in 
the  accounts  of  solvent  debtors,  may  be  difficult  to  locate, 
but  are  none  the  less  important. 

If  the  balances  used  in  the  final  trial  balances  are 
not  brought  down,  then  they  should  be  noted  on  the 
ledger  pages  in  ink.  Preferably,  this  should  be  done  by 
the  office  staff,  but,  if  necessary,  the  auditor  should  do  it 
himself. 

Bad  or  Doubtful  Accounts 

The  schedule  just  referred  to,  in  addition  to  showing 
that  the  balances  due  from  solvent  debtors  are  composed 
of  collectable  items,  should  indicate  each  account  that 
is  overdue,  stating  the  number  of  months  past  due,  so 
that  a  subsequent  classification  can  be  made  to  determine 
the  amount  required  to  be  reserved  to  bring  the  aggre- 
gate due  from  trade  debtors  to  an  amount  which  will 
be  realized  in  cash. 

It  is  not  always  desirable  to  close  a  doubtful  account 
to  profit  and  loss,  nor  is  it  desirable  to  carry  an  account 
long  overdue  among  the  current  accounts.  The  best 
practice,  therefore,  is  to  transfer  the  account  (or  the  sheet, 
if  the  ledger  is  in  loose-leaf  form)  to  a  doubtful  accounts 
ledger,  at  the  same  time  creating  a  reserve  therefor.     The 


372 


AUDITING 


balances  in  this  supplemental  ledger  will  not  be  lost  sight 
of,  as  they  form  part  of  the  trial  balance. 

As  soon  as  an  account  is  known  to  be  irretriev- 
ably bad,  it  should  be  written  off  entirely.  In  the  mean- 
time a  record  of  the  progress  of  collection,  [  such  as 
commencement  of  suit,  etc.,  should  be  noted  on  the 
account. 

Provision  for  bad  accounts  in  the  form  of  a  reserve 
should  be  made  each  month,  based  on  a  percentage  of 
the  total  sales.  This  fixes  in  the  minds  of  all  concerned 
that  losses  may  be  expected  and  stimulates  the  credit  and 
collection  departments  to  keep  down  the  losses  and 
"make  a  profit  on  the  reserve."  Where  this  course  is  not 
followed,  the  auditor  will  have  to  make  the  reserve  large 
enough  to  cover  the  losses  which  his  experience  teaches 
will  be  incurred. 

In  this  respect  managers  and  others  sometimes  mis- 
lead the  auditor  because  they  will  not  admit  the  full 
amount  of  bad  accounts.  After  some  years  of  experience 
an  auditor  finds  that  his  opinion  on  this  point  is  better 
than  anyone  else's  and  he  will  use  his  own  judgment  in 
stating  the  probable  losses.  This  applies  especially  where 
the  business  is  comparatively  old  and  actual  losses  for  a 
series  of  years  can  be  ascertained. 

ASSET  AND  LIABILITY  ITEMS 

From  the  standpoint  of  clients'  relations  to  their  em- 
ployees, the  audit  of  income  and  expenses  is  more  impor- 
tant than  the  audit  of  the  balance  sheet,  but  the  accuracy 
or  inaccuracy  of  the  balance  sheet  affects  proprietors, 
whether  partners  or  stockholders,  also  the  public  as  rep- 
resented by  bankers,  creditors,  prospective  investors,  or  as 
a  basis  of  transfer  from  pne  partner  to  another. 


THE    DETAILED    AUDIT  373 

The  detailed  audit  naturally  includes  a  verification  of 
the  assets  and  liabilities,  and  in  order  to  avoid  repetition, 
the  chapters  on  balance  sheet  audits  (page  59)  should 
be  referred  to  as  indicating  a  part  of  the  program  of  a 
detailed  audit.  Some  balance  sheet  items  are  more  fully 
covered  in  a  detailed  audit  than  in  a  balance  sheet  audit. 
They  will  be  .discussed  at  this  point. 

Notes  Receivable 

The  record  of  notes  received  should  be  examined,  and 
if  comparatively  few  notes  have  been  received,  the  dispo- 
sition of  each  note  should  be  followed  from  the  account 
to  which  credited  until  collected  or  returned  unpaid.  If 
a  large  number  of  notes  have  been  received,  the  auditor 
should  test  the  accuracy  of  the  record  by  selecting  a  few 
months  at  random  out  of  the  year  and  verifying  in  detail 
the  transactions  appearing  in  those  months. 

Notes  Receivable  Protested 

See  that  they  are  charged  back  to  the  individual 
account  of  debtor,  and  that  a  subsequent  attempt  is  made 
to  collect.  The  protested  note  should  be  submitted  as  a 
voucher  or  otherwise  accounted  for  in  all  cases  where  the 
item  is  still  open.  It  would  be  possible  for  a  dishonest 
cashier  to  charge  back  as  unpaid,  items  actually  collected, 
and  subsequently  write  off  the  account  to  bad  debts;  but 
in  such  a  case,  as  no  voucher  could  be  produced,  the  fraud 
would  be  disclosed.  It  is  a  small  matter,  but  the  auditor 
should  ascertain  whether  or  not  all  protest  fees  and 
accrued  interest  are  charged  to  debtors,  as  well  as  the 
face  of  the  notes.  In  many  cases  collection  can  be 
made  subsequently,  and  the  omission  to  charge  all 
proper  items  direct  to  debtors'  accounts  means  a  loss 
thereof. 


374 


AUDITING 


Inventories 

In  a  detailed  audit  this  item  in  the  balance  sheet 
should  be  the  first  to  be  examined  if  there  are  collateral 
indications  that  the  business  has  been  profitable,  even 
though  the  books  shov^^  a  loss.  Inventories  are  frequently 
taken  hurriedly,  materials  in  transit  are  often  omitted, 
or  included  when  the  bills  therefor  have  not  been  entered. 
An  inventory  at  the  beginning  of  a  period  might  be  over- 
valued, and  at  the  end  undervalued,  and  numerous  other 
causes  might  be  cited  to  suggest  errors  which,  if  not 
detected,  result  in  misleading  profit  and  loss  statements. 
In  a  case  of  this  nature  an  auditor  will  find  the  inventories 
a  most  fruitful  source  of  error. 

Here  also  an  auditor  will  have  to  use  good  judgment 
in  passing  values,  for  each  increase  or  decrease  in  an  inven- 
tory affects  the  profit  and  loss  account  correspondingly. 
It  is  about  as  bad  to  pass  undervalues  as  overvalues  where 
the  result  may  be  used  in  an  ulterior  manner.  The  most 
flagrant  cases,  however,  are  overvaluations,  and  with 
these  an  auditor  must  deal  without  fear  or  favor. 

Premiums  and  Discounts  on  Bonds  to  be  Amortized 

Where  bonds  are  sold  at  a  premium,  the  amount  re- 
ceived in  excess  of  the  par  value  represents  the  equiva- 
lent of  interest  collected  in  advance,  and  must  be  held 
in  reserve  and  distributed  over  the  years  to  which  it  applies 
as  a  reduction  in  bond  interest  account.  For  instance,  a 
corporation  may  sell  its  5  per  cent  ten-year  bonds  at  105, 
indicating  that  its  credit  is  rated  on  a  basis  of  about  4i,/2 
per  cent,  that  is,  if  a  4%  per  cent  bond  had  been  issued, 
the  corporation  should  have  realized  about  par.  There- 
fore, the  bond  interest,  when  paid,  is  subject  to  a  deduc- 
tion of  one-half  of  1  per  cent  annually.  The  excess 
received  at  the  time  of  sale  should  not  be  applied  to 


THE    DETAILED    AUDIT  375 

income  or  to  surplus,  but,  as  stated  above,  must  be  car- 
ried as  a  deferred  credit  and  reduced  annually. 

Likewise  when  bonds  are  sold  at  a  discount  it  is 
because  the  rate  of  interest  the  bonds  bear  is  less  than 
the  effective  rate  at  which  the  corporation's  credit  is 
rated.  For  instance,  if  5  per  cent  ten-year  bonds  are 
sold  at  90,  it  means  that  the  corporation's  borrowing 
strength  is  rated  at  about  6  per  cent,  and  in  order  to 
reflect  the  actual  rate  each  year  as  interest  is  paid,  it  will 
be  necessary  to  carry  the  discount  as  a  deferred  charge 
among  the  assets  and  write  off  to  interest  account  1  per 
cent  annually.  This,  added  to  the  amount  paid  in  cash, 
will  adjust  the  interest  account  to  the  proper  cost. 

Premiums  on  Capital  Stock 

With  respect  to  premiums  received  on  capital  stock, 
the  principle  is  different.  There  is  no  liability  on  account 
thereof,  and  no  distribution  to  the  income  of  future  years. 

The  amount  received  is  clearly  a  capital  receipt  and  is 
not  available  as  a  fund  out  of  which  to  pay  dividends;  that 
is,  from  an  accounting  point  of  view.  There  may  be  no 
legal  obstacle  in  the  way  of  crediting  the  premiums  to 
surplus,  and  paying  out  the  entire  surplus  as  dividends, 
but  in  effect  a  board  of  directors  might  as  well  attempt 
to  pay  out  the  remaining  portion  of  the  amount  paid 
for  stock.  Let  us  suppose  that  stock  is  issued  at  $110 
per  share,  $100  being  credited  to  capital  stock,  and  $10  to 
surplus.  If  the  latter  amount  is  distributable,  why  not 
$10  more,  leaving  $90  to  be  credited  to  capital?  The 
answer  would  probably  be  made  that  the  law  will  not 
permit  capital  stock  to  be  issued  at  a  discount,  but  as 
property  of  all  kinds  may  be  turned  in  as  payment  for 
stock,  the  theory  of  stock  being  issued  for  actual  value 
is  a  dead  letter. 


y?^ 


AUDITING 


Premiums  received  on  capital  stock  should  be  credited 
to  an  account  so  entitled  or  to  capital  surplus,  and  should 
not  be  absorbed  in  the  regular  surplus  account. 

Branch  Accounts 

The  extent  of  the  examination  of  branch  accounts  will 
depend  on  the  system  of  accounts  employed.  Where 
local  collections  are  made,  the  accounts  receivable  will 
require  the  same  attention  as  described  on  page  313; 
where  shipments  are  reported  to  the  head  office,  and  col- 
lections are  not  made  locally,  there  will  still  be  the  neces- 
sity of  testing  the  delivery  records  to  ascertain  that  all 
have  been  reported,  and  that  cash  sales,  if  any,  have  been 
duly  accounted  for.  At  the  same  time  the  stock  accounts 
will  require  attention,  both  from  the  point  of  view  of  theft 
or  loss  and  overvaluation. 

Nearly  all  branch  managers  have  an  interest  in  the 
profits  derived  from  their  own  territory,  and  in  conse- 
quence nearly  all  branch  managers  place  the  highest  pos- 
sible valuation  on  their  stock-in-trade.  It  may  seem  diffi- 
cult to  manipulate  the  stock  record  valuations  where 
prices  are  fixed  at  the  head  office,  but  opportunities 
usually  arise  in  connection  with  shopworn  or  obsolete 
stock,  etc.,  and  in  some  cases  quantities  are  deliberately 
overstated. 

Local  expenses  and  purchases  are  usually  reported  to 
the  head  office  in  detail,  so  that  outstanding  liabilities 
should  be  comparatively  easy  to  verify.  If  paid  locally, 
the  usual  precautions  will  have  to  be  taken  to  ascertain 
that  no  omissions  are  made.     (See  page  146.) 

In  some  cases  where  time  does  not  permit  an  auditor 
to  visit  all  branches  personally,  local  auditors  can  be 
employed  to  advantage.  Uniform  instructions  should  be 
sent  out  and  adhered  to  strictly,  so  that  the  auditor  in 


THE    DETAILED     AUDIT 


377 


charge  will  feel  safe  in  using-  the  figures  so  verified. 
Where  this  procedure  is  necessary  the  certificate  should 
be  modified  as  follows: 

'*We  have  audited  (head  office  accounts)  ....  and 
have  compared  the  returns  from  the  several  branches 
therewith  (the  latter  having  been  audited  locally  and 
the  certified  returns  submitted  to  us),  and  in  our  opinion 
they  are  correct,  etc." 

Capital  Expenditure 

Throughout  the  audit  of  expenditure  the  distinction 
between  capital  and  income  must  be  borne  in  mind.  It  is 
sometimes  believed  that  so  long  as  expenditure  for  capital 
outlay,  as  well  as  for  current  maintenance,  is  charged  to 
income  and  not  capitalized,  no  fault  can  be  found  with 
such  a  conservative  course,  but  that  the  reverse  of  this 
practice  cannot  be  justified  under  any  circumstances. 
Theoretically  this  position  is  wrong,  the  proper  rule  being 
to  ascertain  the  correct  application  of  each  payment  and 
to  charge  the  account  to  which  the  item  belongs.  Prac- 
tically, much  can  be  said  in  support  of  what  is  known  as 
the  conservative  method. 

The  great  difficulty  in  ascertaining  the  exact  effect  of 
alterations,  betterments,  and  new  construction,  and  the 
prevailing  tendency  of  managers  and  others  to  emphasize 
the  propriety  of  capitalizing  the  payments,  inevitably 
educate  accountants  and  business  men  who  do  not  want 
to  deceive  themselves,  to  the  determination  to  charge 
to  maintenance  every  item  about  which  there  is  the 
slightest  doubt.  In  other  words,  a  practice  which  is  ob- 
jectionable in  theory  becomes  a  virtue  in  practice,  and  a 
substantial  reason  therefor  is  that  the  business  always 
gains  thereby  and  never  loses. 

The  audit  of  capital  expenditure  is  rarely  satisfactory 


378 


AUDITING 


when  made  by  items,  as  one  item  may  be  chargeable  to 
capital,  while  another  item  of  exactly  the  same  nature 
may  be  chargeable  to  income,  the  distinction  depending 
entirely  on  the  purpose  for  which  used. 

All  well-regulated  concerns  have  a  storeroom  system, 
which  means  that  most  debits  to  plant  accounts  originate 
in  storeroom  charges.  It  is  simply  impossible  to  deter- 
mine long  afterward,  by  a  mere  inspection  of  the  voucher, 
whether  it  should  be  charged  to  one  account  or  another. 

The  most  satisfactory  verification  is  to  secure  a  de- 
pendable memorandum  of  the  additions  and  improvements 
which  have  been  undertaken  or  completed  in  order  to 
increase  the  earning  power  or  ef^ciency  of  the  plant. 
That  is,  if  a  new  building  has  been  erected  or  a  new  power 
plant  installed,  assemble  all  of  the  items  applicable  thereto 
and  compare  the  expenditure  as  a  whole  with  the  esti- 
mated value  of  the  improvement,  or  the  ofificial  authori- 
zation, ascertain  what  it  replaced,  if  anything,  and  what 
additional  capacity  or  economies  are  effected  thereby. 

Odds  and  ends  should  not  be  charged  to  capital,  so 
that  the  increase  in  plant  accounts  for  a  given  period 
should  be  reducible  to  definite  grouping  as  indicated 
above.  If  it  is  found  that  the  total  capacity  of  the  plant 
is  not  materially  increased  by  the  outlay,  it  may  be  in- 
ferred that  the  changes  were  necessary  to  renew  or  replace 
worn-out  or  obsolete  buildings  or  equipment. 

Cash  Discounts  on  Capital  Payments 

It  is  held  by  some  that  the  cash  discounts  deducted 
from  payments  on  account  of  capital  outlay  should  be 
credited  to  interest  or  discount  account  and  be  treated 
as  an  earning.  This,  however,  is  a  fallacy,  as  will  be 
shown  by  a  concrete  example.  Suppose  a  fund  of  $10,000 
is  set  aside  to  buy  machinery;  the  invoices  may  aggre- 


THE    DETAILED    AUDIT 


379 


gate  exactly  $10,000  and  are  subject  to  a  discount  of  2 
per  cent  if  paid  within  ten  days.  Advantage  is  taken  of 
the  discount  and  $9,800  is  paid  out.  It  cannot  be  con- 
tended that  the  cost  is  $10,000  and  an  earning  of  $200 
is  reaHzed,  because  such  is  not  the  fact.  The  machinery 
cost  $9,800  in  cash,  and  the  cash  balance  which  remained 
is  simply  an  unexpended  fund.  It  has  not  been  used  and 
is  now  available  for  other  purposes.  This  is  parallel  with 
the  treatment  of  cash  discounts  on  merchandise  purchases, 
the  net  result  being  the  same  because  the  purchases 
account  is  ultimately  reduced  by  the  amount  of  the  dis- 
count through  the  profit  and  loss  account. 

Real  Estate 

In  any  business  other  than  that  of  real  estate  operat- 
ors there  will  be  few  items  of  cash  payments  in  connec- 
tion with  the  purchase  of  land  or  improved  real  estate. 
More  frequently  it  will  be  found  that  bonds  or  stocks  are 
issued  in  payment  therefor.  Usually  these  items  can  be 
vouched  from  the  minutes  of  boards  of  directors,  the  con- 
tracts themselves  and  the  acknowledgments  of  the  payees. 

An  instance  is  known  of  a  promoter  who  was  made 
the  president  of  a  holding  company  who  paid  himself,  as 
representing  one  of  the  subsidiaries,  a  larger  number  of 
bonds  than  he  was  entitled  to.  The  records  of  the  hold- 
ing company  were  altered  to  fit  the  transaction  and  the 
auditors  were  deceived.  If  the  books  of  the  subsidiary 
company  had  been  examined,  the  fraud  would  have  been 
discovered. 

Buildings 

Where  a  considerable  amount  is  being  expended  on 
new  or  old  buildings,  the  payments  should  be  carefully 
vouched.      Individual   payments,   however,   will   probably 


38o 


AUDITING 


be  supported  by  genuine-looking  vouchers  and  will  not 
reveal  irregularity,  which  may  be  going  on,  either  on  the 
part  of  the  client's  staff  or  on  the  part  of  the  contractor. 
Therefore,  the  operations  as  a  whole  should  be  checked 
with  the  authorizations  of  the  board  of  directors,  or  ex- 
ecutives in  charge  of  the  work,  and  with  the  bids  or  esti- 
mates submitted  before  work  was  commenced. 

Unfortunately  architects'  certificates  as  to  partly  com- 
pleted work  are  not  always  reliable,  on  account  of  the 
connection  which  sometimes  exists  between  contractors 
and  architects,  and  in  rare  cases  only  can  an  auditor  go 
behind  these  certificates. 

It  is  permissible  to  charge  all  expenses  and  outlays  in 
connection  with  these  operations,  such  as  permits,  archi- 
tects' and  engineers'  fees,  clerical  salaries  when  clearly 
applicable  to  new  work,  and  similar  items,  to  the  work 
itself.  It  may  seem  more  conservative  to  charge  part  of 
this  expenditure  to  revenue,  but  in  all  cases  it  is  preferable 
to  assemble  all  costs  into  one  account,  then  if  it  appears 
desirable  to  write  off  a  part  of  the  cost,  it  can  be  done 
at  any  time.  The  whole  cost,  however,  having  once  ap- 
peared in  one  account,  will  subsequently  be  available  for 
any  desired  information. 

Where  new  buildings  are  erected  in  whole,  or  in  part, 
by  the  concern  itself,  it  is  important  to  ascertain  that  no 
profit  is  included.  Auditors  frequently  find  this  state  of 
affairs  and  are  met  with  the  argument  that  if  the  contract 
had  been  awarded  to  an  outside  concern,  a  contractor's 
profit  would  have  been  added.  A  concern  not  in  the 
contracting  business  cannot  always,  however,  erect  a 
building,  or,  in  fact,  perform  any  work  outside  of  its 
usual  operations,  at  the  same  cost  as  one  whose  sole 
efforts  are  devoted  to  this  class  of  work  and  who  may  be 
depended  upon  to  have  discovered  economies  in  purchas- 


THE    DETAILED    AUDIT  381 

ing,  planning-,  and  executing  not  possible  except  after 
long  experience.  If  an  actual  saving  has  been  effected, 
it  is  not  a  realized  profit  and  should  not  be  treated  as 
such.  The  asset  account  should  represent  cost  and  no 
more. 

Cost,  however,  can  include  interest  paid  on  borrowed 
money  used  for  construction  purposes.  Otherwise  a  con- 
cern might  find  that  a  profit  and  loss  deficit  existed  with 
respect  to  a  new  plant,  before  its  completion.  After  com- 
pletion a  plant  is  expected  to  earn  a  sufficient  profit  to 
cover  interest,  but  it  would  be  unreasonable  to  apply 
such  a  rule  before  its  earning  power  became  possible. 

Improvements  and  Extensions 

These  terms  are  descriptive  in  themselves,  but  they 
are  hard  to  define  in  practice;  that  is,  hard  for  an  auditor 
to  define.  An  executive  or  the  man  in  charge  of  the  job 
has  no  such  difficulty.  Every  new  job  is  an  improvement, 
an  addition,  or  an  extension,  and  the  entire  cost  is  to  be 
capitalized.  The  fact  is  that  practically  no  part  of  a  plant 
is  renewed  or  replaced  in  exactly  its  former  state.  Almost 
invariably  it  is  enlarged  or  otherwise  changed  for  the 
better,  so  that  there  is  some  basis  for  the  designation 
referred  to.  If  there  is  no  increased  earning  capacity  the 
question  is  simplified,  but  even  here  we  cannot  lay  down 
a  hard  and  fast  rule  that  no  part  of  the  new  cost  must  be 
capitalized. 

Suppose  a  railroad  company  demolishes  an  old  wooden 
station  and  erects  in  its  place  a  larger  and  more  ornate 
structure  of  brick  and  stone,  at  a  cost  of  $100,000  in 
excess  of  the  book  value  of  the  old  building.  It  may  be 
assumed  that  the  earning  capacity  is  not  materially  in- 
creased; probably  the  maintenance  cost  of  the  new  struc- 
ture is  greater  than  that  of  the  old.     The  argument  will 


2^2  AUDITING 

be  used  that  the  traveling  public  demands  beauty  as  well 
as  utility,  and  there  is  an  actual,  if  almost  imperceptible, 
increased  earning  potentiality  in  the  more  handsome 
structure. 

The  same  point  arises  in  manufacturing  concerns. 
Large  and  expensive  office  buildings,  recreation  facilities 
and  similar  expenditures  are  made  without  any  apparent 
increase  in  earning  capacity. 

The  auditor  will,  of  course,  decide  each  case  on  its 
merits.  Wherever  possible  such  expenditures  should  be 
charged  to  expenses.  If  the  expenditures  are  large  and 
of  infrequent  occurrence,  it  may  be  permissible  to  spread 
them  over  a  period  of  two  to  five  years.  This  may  seem 
to  be  rather  drastic  practice,  but  between  the  alternative 
of  loading  the  plant  account  to  the  danger  point — as  so 
often  happens — and  keeping  it  down  to  a  safe  and  sane 
basis,  there  should  be  Httle  argument  as  to  which  is  better 
accounting. 

Another  somewhat  uncertain  point  in  plants  where 
improvements  or  extensions  are  being  made  at  intervals, 
is  the  selection  of  the  proper  account  to  which  the  salary 
of  a  manager  or  a  superintendent  should  be  charged.  It 
•may  be  that  the  entire  time  of  these  officials  is  devoted  to 
the  new  construction  while  it  is  going  on,  and  there 
might  be  some  justification  for  capitalizing  part  of  such 
cost. 

Here  again  is  a  case  of  doubt  which  should  be  decided 
in  favor  of  conservative  practice.  As  heretofore  stated, 
work  of  this  nature  performed  partly  or  entirely  by  a 
concern  not  in  the  building  trade,  will  usually  cost  more 
than  if  contracted  for  outside.  There  may  be  good 
reasons  for  not  having  the  work  done  outside,  but  there 
is  no  good  reason  for  running  up  the  book  cost  beyond 
its  replacement  value. 


THE    DETAILED    AUDIT 


383 


If  left  to  the  auditor  to  decide,  he  should  not  load 
the  plant  account  with  any  general  expense  items  such 
as  managers'  or  superintendents'  salaries. 

Machinery,  etc. 

The  important  point  to  keep  in  mind  in  connection 
with  purchases  of  machinery,  tools,  fixtures,  etc.,  is 
whether  they  represent  actual  additions  to  plant  and 
equipment,  or  whether  they  are  renewals.  This  point  is 
covered  in  Chapter  XVIII,  "Depreciation."  The  cost  of 
installation,  including  freight,  labor,  and  other  items,  is 
as  much  a  part  of  the  cost  as  the  price  of  the  machinery 
itself. 

Where  machines,  etc.,  are  built  by  the  concern  itself, 
the  remarks  found  above  under  "Buildings"  will  also 
apply. 

Where  machines  have  been  purchased  upon  the  partial 
payment  or  instalment  plan  it  is  customary  to  charge  the 
entire  purchase  price  to  the  machinery  account  and  credit 
the  vendor.  As  the  monthly  or  other  periodical  payments 
are  made  the  vendor's  account  is  charged  and  finally 
closed.  Interest  is  usually  included  in  the  gross  purchase 
price,  but,  of  course,  does  not  form  part  of  the  price  if 
cash  is  paid.  The  proper  entry  is  to  debit  machinery  with 
the  cash  price,  and  debit  the  interest  account  with  the 
balance.  i 

On  the  balance  sheet,  if  prepared  before  the  last 
payment  is  made,  the  value  of  the  machinery  less 
depreciation  and  less  instalments,  should  be  shown,  net, 
among  the  assets.  It  is  not  proper  to  set  up  the  cost  as 
an  asset  on  one  side  and  the  unpaid  balance  as  a  liability 
on  the  other  side,  unless  the  fact  as  to  the  lien  is  fully 
disclosed. 

Machines  are  sometimes  purchased  under  an  agree- 


3^4 


AUDITING 


ment  that  a  royalty  will  be  paid  on  the  output.  The 
royalty  payments  will  be  charged  to  operating  expenses 
and  have  no  connection  with  the  purchase  price  so  far  as 
the  books  are  concerned.  The  value  of  the  machine  is 
set  up  as  an  asset  and  depreciated  on  the  basis  of  the 
effective  life  of  the  machine. 

If  the  payments  extend  over  several  years  the  interest 
applicable  to  subsequent  years  may  be  set  up  as  a  deferred 
charge.  If,  at  the  time  the  balance  sheet  is  prepared, 
any  instalments  are  overdue,  or  if  they  have  not  been 
paid  promptly,  it  may  be  that  the  equity  will  be  lost 
through  the  retaking  of  the  machines  by  the  manufac- 
turer. This  possibility  must  be  considered  in  valuing  the 
item. 

Notes  Payable 

All  notes  paid  during  the  period  under  audit  should 
be  submitted  as  vouchers.  If  notes  are  issued  from  a  stub 
book,  or  if  a  special  form  is  used,  all  should  be  accounted 
for.  Spoiled  notes  should  be  pasted  on  their  respective 
stubs  as  is  done  with  cheques. 

If  careful  consideration  is  given  to  the  notes  issued 
during  the  period,  it  will  assist  the  auditor  to  determine 
whether  all  notes  outstanding  at  the  date  of  the  balance 
sheet  appear  thereon. 

In  a  detailed  audit  the  auditor  will  find  better 
opportunities  for  securing  information  relative  to  notes 
payable  outstanding,  but  omitted  from  the  books,  than 
in  the  case  of  a  balance  sheet  audit.  In  the  former  case 
analyses  of  cash  receipts,  interest,  discount,  bonuses  paid, 
and  credits  to  the  personal  accounts  of  partners  and 
officers  of  corporations,  may  disclose  clues  as  to  unentered 
or  misapplied  liabilities. 

An  auditor  had  completed  his  examination  and  was 


THE    DETAILED    AUDIT  385 

about  to  deliver  the  report  when  he  accidentally  stopped 
in  at  a  bank  on  the  way  to  the  client's  office.  The  cashier 
spoke  of  the  audit  and  inquired  whether  the  auditor 
thought  that  a  note  for  $15,000,  due  the  following  month, 
would  be  paid.  The  auditor  knowing  that  no  such  item 
appeared  on  the  balance  sheet  nor  in  the  books,  asked  to 
see  the  note.  He  found  that  it  was  a  company  note 
executed  by  the  treasurer,  who  had  received  and  misap- 
propriated the  proceeds  without  passing  any  entry 
therefor  through  the  books.  The  auditor  would  have 
discovered  the  fraud  if  he  had  taken  the  precaution  to  ask 
the  bank,  during  the  course  of  the  audit,  if  it  held  any  obli- 
gations of  the  company. 

In  checking  up  the  canceled  or  paid  notes  the  indorse- 
ments should  be  examined.  Many  notes  are  made  to  the 
order  of  and  indorsed  by  the  payee,  but  if  discounted  will 
bear  the  rubber  stamp  indorsement  or  cancellation  mark 
of  the  bank.  If  there  are  no  such  marks,  inquiry  should 
be  made,  although  an  overdue  note  can  hardly  cause  much 
trouble. 

See  page  154  for  a  more  complete  discussion  of  notes 
payable. 

Partners'  Withdrawals 

If  payments  are  made  in  currency,  partners  should 
approve  their  accounts  as  they  appear  in  the  ledger. 

The  practice,  so  prevalent,  of  drawing  comparatively 
small  amounts  at  a  time  and  initialing  a  voucher,  or 
declining  to  give  one  at  all,  is  a  direct  temptation  to 
dishonesty  on  the  part  of  the  cashier.  Auditors  should 
criticize  the  practice  vigorously  and  suggest  to  part- 
ners that  their  withdrawals  be  by  cheque  only,  and  that 
they  pay  their  personal  bills  through  their  own  bank 
accounts. 


386  AUDITING 

Dividends 

The  audit  of  dividend  payments  is  simple.  Authoriza- 
tion must  always  be  found  in  the  board  minutes,  and  any 
dividend  declared,  if  paid,  must  be  paid  to  all  stockholders 
of  record  at  the  date  named.  Dividends  cannot  be  declared 
as  of  a  past  date,  but  may  be  dated  ahead  as  far  as  may  be 
desired. 

In  the  case  of  Jones  v.  Terre  Haute  &  Richmond 
R.  R.  Co.  (57  N.  Y.  196),  Commissioner  Reynolds 
said : 

It  is  certainly  true,  as  a  general  rule,  that  a  stockholder  in  a  cor- 
poration has  an  interest  in  proportion  to  his  stock  in  all  the  corporate 
property  and  has  a  right  to  share  in  any  surplus  of  profits  arising  from 
its  use  and  employment  in  the  business  of  the  company;  and  this  legal 
right  does  not  depend  upon  the  question  whether  he  is  a  stockholder  of 
long  standing  or  of  recent  date.  The  moment  a  person  becomes  stock- 
holder in  a  corporation,  all  the  incidents  of  interest  or  quasi-ownership 
in  the  corporate  property  attach. 

In  another  New  York  case  the  court  refused  to  order 
the  directors  to  pay  additional  dividends,  although  the 
corporation  had  a  very  large  surplus,  part  of  which  was  in 
bank  and  represented  a  sum  far  in  excess  of  that  actually 
required  for  current  purposes,  and  part  of  which  was 
invested  in  outside  securities.  The  court  said,  'The 
discretion  of  the  directors  in  regard  to  declaring  dividends 
will  not  be  interfered  with  in  the  absence  of  fraud  or  an 
abuse  of  discretion." 

Stock  Dividends 

Dividends  are  supposed  to  be  distributions  of  earnings 
and  accrue  to  the  stockholder  only  at  the  time  of  declara- 
tion. A  stockholder  in  a  corporation  having  a  large 
surplus  and  earning  several  times  the  amount  of  its 
dividends  is  no  more  justified  in  taking  a  proportionate 


THE    DETAILED    AUDIT 


387 


part  of  an  expected  dividend  into  his  accounts  as  income 
than  he  would  be  in  assuming  that  the  entire  surplus 
would  be  divided.  When  the  dividend  is  actually  declared 
and  becomes  an  obligation  of  the  corporation,  it  becomes, 
in  turn,  income  receivable  to  the  stockholder. 

In  the  case  of  a  stock  dividend  the  rule  also  applies, 
the  only  exception  being  where  the  dividend  is  an  extraor- 
dinary one  and  where  the  distribution  includes  the  surplus 
of  two  or  more  years  which,  as  a  matter  of  fact,  has  been 
capitalized. 

Not  long  ago  the  Standard  Oil  Company  of  Indiana 
declared  a  stock  dividend  of  2,900  per  cent;  that  is, 
the  holder  of  $100  in  stock  received  additional  stock 
amounting  to  $2,900.  Suppose  the  owner  of  one  share 
died  shortly  before  the  declaration  of  the  dividend,  leaving 
the  income  of  his  estate  to  his  wife  for  Hfe  and  the 
principal  to  his  children,  the  stock  would  have  been 
appraised  at  perhaps  $2,000,  based  on  earnings  of,  say, 
10  per  cent  per  annum  on  that  price.  If  the  principle 
that  dividends  are  income  were  applied,  the  widow  would 
receive  the  $2,900  per  share  in  new  stock,  and  at  her 
death,  if  no  other  change  took  place,  the  children  would 
receive  the  original  share,  worth  now  only  $100  and  yield- 
ing perhaps  7  per  cent  per  annum.  v^This  would  be  so 
inequitable  and  so  at  variance  with  the  testator's 
intentions  that  most  of  the  states  would  permit  the 
dividend  to  be  treated  as  a  distribution  of  principal  and 
not  of  income.  ) 

Precisely  the  same  rule  should  apply  where  stocks  are 
carried  on  balance  sheets  at  very  high  figures  and  are 
reduced  in  price  per  share  through  the  distribution  of 
large  stock  dividends.  Unless  it  is  very  clear  that  the 
declaration  consists  of  the  earnings  of  a  recent  period, 
the  whole  dividend  should  be  treated  as  capital.     If  it  can 


388  '        AUDITING 

be  apportioned,  it  would  be  proper  to  apply  that  part  of 
it  representing  a  distribution  of  the  earnings  of  the  last 
year  or  period  to  current  income.  Where  state  laws 
govern  the  matter  the  laws  must  be  observed.  The 
auditor  should  be  thoroughly  informed  as  to  the  provi- 
sions of  the  law  in  this  respect  in  his  own  state  and  in 
any  others  where  he  practices. 

Capital  Stock 

A  trial  balance  should  be  taken  of  the  stock  ledger 
to  see  that  the  aggregate  outstanding  is  in  agreement 
with  the  general  ledger  account.  It  should  be  noted  if 
there  is  any  account  in  the  name  of  the  company  or  its 
treasurer,  which  was  intended  to  represent  treasury  stock, 
but  which  may  or  may  not  be  such. 

The  stock  certificate  books  should  be  examined  and 
reconciled  with  the  stock  ledger.  All  canceled  certificates 
should  be  inspected  or  accounted  for. 

Bonds 

A  proof  should  be  taken  of  the  bond  ledger  or  register 
to  ascertain  that  the  aggregate  outstanding  is  correct 
and  is  in  agreement  with  the  general  ledger.  Canceled 
bonds  should  be  inspected  or  accounted  for.  The  bond 
agreement  should  be  read,  and  if  it  contains  any  provi- 
sions as  to  sinking  funds,  etc.,  it  should  be  seen  that  these 
are  carried  out  or  report  made  thereon. 

All  bonds  which  have  been  certified  by  the  trustee  and 
delivered  to  the  corporation  must  be  accounted  for.  If 
they  have  been  sold  for  cash  or  issued  for  property,  the 
proceeds  should  be  followed  to  see  that  proper  entries 
have  been  made  therefor,  thus  rendering  a  subsequent 
audit  possible.  If  any  bonds  have  not  been  sold  and  are 
supposed  to  be  on  hand  as  treasury  bonds,  the  auditor 


THE    DETAILED    AUDIT 


389 


should  ask  to  see  them.  Frequently  treasury  bonds  are 
deposited  as  collateral  for  loans,  and  as  this  fact  must 
appear  on  the  balance  sheet  the  auditor  should  be  sure  to 
ascertain  the  facts. 

It  should  be  determined  whether  or  not  the  amount 
of  interest  accrued  has  been  set  up  in  the  accounts  and 
whether  the  amount  due  has  been  paid. 

Careful  methods  should  be  in  force  relative  to  coupons. 
They  should  be  canceled  effectively  immediately  upon 
receipt,  and  kept  on  file,  not  destroyed.  The  auditor 
should  see  that  the  canceled  coupons  are  accounted  for. 

Taxes 

Corporations  are  subject  to  special  taxes,  such  as  the 
Federal  Income  and  War  Taxes,  State  Franchise  Tax,  etc. 
The  auditor  should  see  that  these,  as  well  as  the  usual 
taxes  on  property,  are  provided  for. 

In  New  York  State  there  is  a  tax  of  two  cents  per 
hundred  dollars  of  par  value  or  fraction  thereof,  imposed 
on  all  transfers  of  stock.  The  seller  of  the  stock,  or  his 
broker,  pays  this  tax  by  affixing  revenue  stamps  to  the 
certificate  surrendered.  The  officer  of  the  corporation, 
however,  who  transfers  the  stock  or  causes  it  to  be 
transferred  is  liable  to  the  penalty  for  failure  to  pay  the 
tax. 

OFFICE  METHODS 

In  nearly  every  audit  where  no  previous  work  had 
been  done  for  the  client,  the  auditor  was  formerly  asked 
to  note  any  improvements  or  changes  which  might  occur 
to  him  during  the  progress  of  the  audit.  It  did  not  seem 
incongruous  that  a  professional  accountant  whose  whole 
time  was  spent  in  examining  and  criticizing  accounts 
should  in   the  course  of  an  extensive  practice  acquire 


390 


AUDITING 


experience  of  great  value,  and  that  he  should  be  able  to 
give  to  new  clients  the  benefit  of  such  experience.  At  the 
present  time  there  is  somewhat  of  a  feeling  that  the 
auditor  is  not  a  specialist  in  system  work  and  that  in 
order  to  be  up-to-date  an  ''efficiency  engineer"  must  be 
employed.  But  suppose  we  compare  present  conditions 
with  those  of  about  ten  years  ago.  At  that  time  station- 
ery houses,  which  carried  an  ''auditing  department"  as  a 
side  line,  were  making  a  great  stir  through  advertising 
and  traveling  solicitors,  and  were  offering  to  produce 
wonderful  results,  including  daily  balance  sheets  and  profit 
and  loss  statements,  the  only  requirement  being  the 
installation  of  their  patented  stationery.  Offices  were 
turned  inside  out  and  new  books  and  blanks  were  installed 
by  the  ton,  but  for  some  reason  the  service  did  not 
measure  up  to  the  promises,  and  hundreds  of  offices  dis- 
carded much  of  the  "junk"  which  had  been  thrust  upon 
them  and  went  back  to  saner  methods. 

For  a  short  time  the  auditor  was  back  in  favor.  He 
had  no  cut-and-dried  system,  nor  did  he  know  before  he 
entered  an  office  how  its  system  should  be  mapped  out, 
but  out  of  long  experience  he  was  able  to  make  sugges- 
tions which  cut  out  unnecessary  work  and  proposed 
changes  which  embraced  the  use  of  all  the  latest  labor- 
saving  devices.  Then  came  the  "efficiency  engineer,"  who 
again  modestly  affirmed  that  the  auditor  was  not  a 
specialist  in  systems  and  that  he  could  not  be  expected 
to  keep  his  clients  up-to-date.  The  crop  of  over-charged 
and  dissatisfied  patrons  of  the  "efficiency  engineer"  is 
commencing  to  be  heard  from,  and  it  is  believed  by  some 
who  have  studied  the  situation  that  before  long  the 
auditor  will  be  back  in  his  former  position  as  a  recognized 
authority  on  business  systems. 

The  auditor  should  keep  fully  informed  on  the  latest 


THE    DETAILED    AUDIT 


391 


devices,  mechanical  and  other  kinds,  for  saving  labor  or 
rendering  it  more  efficient;  he  should  understand  and  be 
prepared  to  explain  the  relation  of  one  department  of  a 
business  to  another  and  the  advantages  of  co-ordination; 
he  should  study  cost  systems  and  be  ready  to  install  any 
required  accounting  system;  he  should  acquire  and  follovy 
up  a  knowledge  of  the  means  of  imparting  information  by 
means  of  charts  and  other  visual  methods. 

It  might  be  urged  that  an  auditor  cannot  hope  to 
cover  more  than  a  small  part  of  the  field  of  auditing 
within  a  considerable  period  of  practice,  and  that  to 
expect  him  to  add  the  work  of  a  system  specialist  is 
unreasonable.  The  answer  to  this  is  that  no  one  can  be 
a  good  auditor  without  picking  up  all  of  the  rudiments  of 
systematizing,  and  that  in  any  event  system  is  a  matter 
of  evolution. 

Ready-made  systems  have  been  popular,  but  never 
successful.  No  system  will  work  out  well  unless  a  good 
man  studies  the  concern  and  becomes  acquainted  with  its 
personnel  before  he  starts,  and  then  ''lives  with  the  job" 
until  its  completion.  The  auditor  may  not  be  able  to 
handle  many  such  engagements,  but  he  should  not  allow 
the  so-called  system  experts  to  blufif  him  out  of  the  remu- 
nerative work.  He  is  probably  better  qualified  to  perform 
it  than  anyone  else. 

Styles  of  Books  and  Records 

The  auditor  will  note  by  actual  inspection  w^hether 
the  records  are  kept  economically  and  efficiently  or  other- 
wise. If  the  old-fashioned  bound  books  are  in  use  and 
loose-leaf  records  would  be  an  improvement,  he  should 
recommend  a  change.  On  the  other  hand,  it  may  be  that 
some  records  are  being  kept  on  cards  or  loose  leaves 
which  could  be  written  up  more  readily  and  referred  to 


392 


AUDITING 


more  easily  in  bound  books.     In  such  a  case  the  latter 
would  be  recommended. 

In  view  of  the  elasticity  and  convenience  of  cards  and 
loose-leaf  records,  these  systems  are  becoming  more  and 
more  popular.  In  the  early  stages  it  was  feared  that  the 
leaf  or  card  might  be  lost,  destroyed,  or  easily  altered, 
but  after  a  number  of  years  of  experience  this  fear  has 
practically  disappeared. 

Filing  Systems 

With  the  unit  system  of  records  has  come  the  unit 
system  of  filing.  Press  copy  books  are  becoming  a  rarity 
and  have  been  discarded  by  most  modern  offices.  Docu- 
ments, correspondence,  etc.,  are  now  filed  in  vertical  files 
and  in  such  a  form  as  to  be  readily  accessible. 

In  many  modern  offices  the  method  is  in  force  of 
making  a  carbon  copy  of  each  letter,  and  in  the  mailing 
department  a  press  copy  in  a  letter  book.  The  carbon 
copy  takes  the  place  of  a  ''tickler"  and  is  filed  so  that  it 
will  come  up  for  further  attention  on  the  day  decided 
upon.  The  letter  book  impression  is  taken  just  before  the 
letter  is  put  in  the  envelope  and  records  the  signatures 
and  other  identifying  marks.  It  is  properly  indexed,  and 
becomes  a  safeguard  against  the  loss  of  the  carbon  or 
the  unwarranted  alteration  of  the  letter. 

The  essential  features  of  a  filing  system  are: 

1.  Certainty  of  obtaining  any  paper  or  all  papers  on 
a  particular  subject. 

2:  Rapidity  of  obtaining  filed  papers. 

3.  Rapidity  of  filing  papers. 

4.  Cheapness  of  operation. 

5.  SimpHcity. 

6.  Small  space  required. 

7.  Cross-reference,  numbering,  etc. 


THE    DETAILED    AUDIT  393 

In  a  report  on  the  handling  and  filing  of  correspon- 
dence, President  Taft's  Commission  on  Economy  and 
Efficiency  makes  the  following  suggestions,  which  apply 
with  as  great  force  to  the  average  business  corporation  as 
to  the  government  service: 

1.  That  all  correspondence  shall  be  filed  flat  in  vertical  files. 

2.  That  all  correspondence  should  be  filed  by  subjects  arranged 
upon  a  self-indexing  basis. 

3.  No  book  or  card  record  of  correspondence  is  desirable. 

4.  That  carbon  copies  should  supplant  press  copying. 

5.  That  the  employment  of  the  dictation  machine  (phonograph) 
for  dictating  should  be  extended  widely. 

6.  That  transparency  or  "window"  envelopes  should  be  used. 

7.  That  forms  that  must  be  filled  in  on  the  typewriter  should  be 
so  arranged  as  to  facilitate  the  work. 

8.  That  on  internal  correspondence  no  salutation  or  complimentary- 
closing  should  be  used  and  that  the  initials  of  the  person  addressed  and 
the  writer  should  be  used  instead  of  full  names. 

Copying 

Where  large  quantities  of  copies  are  desired,  there 
are  the  multigraph,  the  revolving  duplicator,  and  the  old- 
fashioned  fiat  duplicator.  The  revolving  duplicator  is 
perhaps  the  most  popular,  requiring  only  the  typewriting 
of  a  waxed-paper  stencil.  For  work  requiring  more  than 
a  thousand  impressions,  the  multigraph  or  one  of  the 
several  makes  of  printing  machines  is  preferable. 

Mailing  Department 

The  handling  of  mail  is  important  and  has  come  to  be 
a  separate  department.  Incoming  mail  usually  contains 
remittances  in  cheques  and  cash,  and  has  proven  in  more 
cases  than  one  a  simple  source  of  illegitimate  wealth  to 
enterprising  but  ill-paid  clerks  and  cashiers.  Some 
responsible  person — preferably  an  officer  of  the  com- 
pany— should  have  charge  of  the  incoming  mail.    As  it  is 


394  AUDITING 

opened  it  should  be  distributed  to  baskets  designated  for 
the  various  departments,  and  should  be  delivered  with  as 
much  care  as  is  used  in  opening  it. 

Outgoing  mail  must  be  handled  differently.  It  is 
desirable  to  have  the  stenographers  who  write  letters 
address  the  envelopes  at  the  same  time,  and  then,  instead 
of  delivering  them  both  to  the  executive,  the  letter  only 
should  be  delivered,  and  the  envelope  (together  with  any 
inclosures)  sent  to  the  mailing  department.  When  the 
letter  has  been  signed  it  is  sent  to  the  mailing  department, 
where  it  is  put  in  the  envelope,  with  the  inclosures,  and 
is  sealed,  stamped,  and  mailed.  It  is  the  duty  of  the 
mailing  department  to  keep  posted  on  changes  in  closing 
hours  for  the  various  domestic  and  foreign  mails. 

Stock  on  Hand 

In  many  cases  the  auditor  will  find  it  practicable  to 
introduce  a  perpetual  inventory  of  stock  on  hand.  He 
may  base  his  suggestions  on  the  following  general  recom- 
mendations quoted  from  'The  Accountant's  Manual," 
Vol.  II: 

1.  Debit  and  credit  accounts  should  be  opened,  as  far  as  possible, 
for  each  description  of  stores  used.  On  one  side  of  the  accounts  the 
receipts  would  be  entered,  showing  the  date,  weight,  quantity,  or  num- 
ber, and  other  particulars ;  and,  on  the  other  side,  the  stores  issued  from 
time  to  time  would  be  entered,  with  such  particulars  as  were  necessary 
or  suitable,  the  difference  representing  what  ought  to  be  in  hand,  or 
thereabouts,  as,  in  accounts  of  this  kind,  the  balance  shown  upon  the 
accounts  can  hardly  be  depended  upon  exactly. 

2.  It  is  the  opinion  of  practical  mill  owners  and  managers  that  in 
many  cases  a  really  efficient  and  exact  check  on  stores  is  not  practicable. 
It  could,  no  doubt,  be  devised,  but. the  detailed  work  in  connection  with 
it,  and  consequent  labor  and  expense,  put  it  out  of  the  range  of  every- 
day business,  whatever  theorists  may  say.  But  many  useful  rules  may 
be  laid  down  preventive  of  fraud  and  waste,  arnongst  others  the  follow- 
ing, taken  from  actual  experience : 

(a)  Where  stores  are  distributed  for  use  upon  a  specific  job,  the 
job  should  be  stated,  with  the  weight,  quantity,  etc. 


THE    DETAILED    AUDIT  395 

(b)  If  material  of  the  same  kind  is  distributed  to  various  men  for 
the  same  purpose,  a  comparison  should  be  made  between  the  results 
produced  by  each.  If  discrepancies  are  found,  inquiries  should  be 
made,  and  doubtless  in  some  cases  a  good  explanation  could  be  given: 
e.g.,  use  of  old  machinery  or  appliances,  etc. 

(c)  The  storeroom  should  be  situated  in  a  convenient  place,  and 
be  in  charge  of  a  competent  man  who  combines  practical  knowledge  of 
the  stores  with  sufficient  bookkeeping  experience  to  appreciate  the 
importance  of  account  keeping. 

(d)  The  principal,  or  manager,  should  make  a  point  of  examining 
at  times  the  stock  ledgers  and  exercising  general  supervision  of  the 
department.  Frequent  and  unnotified  visits  should  be  made,  and  the 
storekeeper,  if  possible  (it  is  not  always  possible),  changed  (occa- 
sionally). 

(e)  Some  kinds  of  stores  should  never  be  given  out  unless  the 
used-up  stores  are  returned.  For  example,  a  workman  making  requisi- 
tions for  files,  brushes,  and  like  things,  should  be  supplied  only  on  his 
giving  up  the  old  articles.  This  is  a  very  good  check  when  the  nature 
of  the  stores  will  allow  of  its  application. 

Stock  accounts  should  show  quantities  as  well  as 
values,  the  one  forming  a  good  check  upon  the  other. 

The  forms  used  should  provide  for  an  opening  balance 
or  inventory,  to  which  are  added  daily  the  quantity  and 
value  of  the  material  purchased  or  manufactured.  There 
should  be  provision  for  totaling  these  debits  and  for 
deducting  therefrom  the  quantity  sold  and  the  cost  value 
of  same.  The  balance  should  agree  with  an  actual 
inventory. 

A  more  detailed  form  used  by  many  concerns  provides 
columns  to  show  not  only  the  balance  and  purchases  daily, 
but  also  the  sales  and  the  new  balance.  Noted  at  the  top 
of  the  sheet  or  card  is  the  minimum  quantity  of  stock  to 
be  carried,  as  well  as  the  maximum  quantity.  Whenever 
the  stock  reaches  a  low  point,  the  records  are  checked  by 
comparison  with  an  actual  inventory.  Thus  the  taking 
of  inventory  is  not  left  until  the  end  of  the  period,  but  is 
taken  continuously. 


396  AUDITING 

Business  today  is  so  varied  in  its  nature  that  some 
lines  will  not  permit  of  a  regular  system  of  stock 
accounts — nor  is  it  especially  necessary,  as  in  the  case  of 
traders  dealing  in  small  articles  broken  from  bulk.  While 
different  methods  of  check  must  be  employed  in  such 
cases,  there  are  some  general  forms  which  may  be 
adopted  and  will  be  found  practicable  for  ordinary  lines  of 
business. 

Every  trade  is  supposed  to  earn  a  certain  percentage 
of  gross  profit,  which  should  be  based  on  the  cost  price  of 
goods  and  not  on  the  selling  price.  If,  therefore,  a  stock 
account  is  started  with  the  actual  stock  on  hand  valued 
at  the  purchase  price,  and  there  are  added  to  it  the  total 
quantity  purchased*  from  time  to  time  (say  monthly),  and 
also  the  estimated  gross  profits  referred  to,  this  amount, 
less  the  total  sales,  should  show  the  stock  on  hand,  assum- 
ing that  the  gross  profit  named  has  been  exactly  earned. 
By  deducting  the  gross  profit  from  the  sales  and  then 
crediting  the  stock  account,  the  same  result  would  be 
secured.  This  book-figure  can  easily  be  verified  or  corrected 
at  the  time  of  actual  inventory. 

Another  common  and  often  useful  practice  in  testing 
the  accuracy  of  the  stock  at  any  time  is  to  make  a  com- 
parison between  the  stock  and  sales  for  a  particular  period 
and  a  corresponding  period  of  prior  years,  though. this  is 
only  a  rough  test  and  not  definite. 

The  accounts  of  an  establishment  handling  various 
kinds  of  goods  should  be  so  kept  that  the  position  of  the 
various  departments  as  to  purchases,  sales,  etc.,  may 
readily  be  secured.  Such  a  system  serves  two  most  useful 
purposes:  (1)  Attention  is  directed  to  any  discrepancy 
between  actual  and  estimated  gross  profits  by  means  of 
a  like  difference  between  a  physical  and  the  book  inven- 
tory.   (2)  Needed  information  is  furnished  from  month  to 


THE    DETAILED    AUDIT  397 

month  as  to  the  probable  amount  of  stock  in  each 
department,  and  this  knowledge  serves  as  a  guide  to  and 
check  upon  the  various  departmental  managers,  as  well 
as  affording  material  for  an  interim  balance  sheet,  if  one 
is  desired. 

Where  a  more  accurate  check  on  the  various  depart- 
ments is  desired,  the  following  method  is  employed :  All 
goods  are  charged  to  departments  at  the  selling  price, 
this  having  been  determined  in  advance.  Any  changes 
in  value  are  recorded  and  when  the  inventory  is  taken  it 
is  priced  both  at  cost,  for  the  private  office,  and  also  at 
selling  price,  for  the  purpose  of  verification,  and  the 
account  is  supposed  to  balance  exactly.  Houses  whose 
business  reaches  a  large  volume  find  this  system  gives 
satisfactory  results  with  but  slight  discrepancies.  It  can 
be  extended,  too,  with  advantage  to  other  trades,  such 
as  retail  branch  stores  selling  cigars,  groceries,  men's 
furnishing  goods,  and  similar  lines. 

To  furnish  conclusive  information  relative  to  gross 
profits  made  in  various  retail  lines  is,  of  course,  impossible. 
Situation,  nature  of  the  business,  policy  of  the  manage- 
ment, local  conditions — all  enter  into  the  result  so  that 
any  attempt  to  outline  even  approximate  figures  would 
be  unwise  and  misleading.  However,  any  auditor  might 
compile  a  table  out  of  his  own  experience  that  Would 
prove  of  value. 

If  it  becomes  necessary  for  the  auditor  to  design  stock 
accounts  for  any  particular  business,  he  may  well  take 
advantage  of  whatever  practical  experience  is  possessed  by 
his  clients  or  their  managers,  supplementing  such  knowl- 
edge by  his  own  experience,  and  if  he  should  be  so  fortu- 
nate as  to  have  an  intimate  acquaintance  with  the  special 
business  in  hand,  he  will  undoubtedly  find  it  of  the 
greatest  assistance. 


398  AUDITING 

Controlling  Subsidiary  Ledgers 

There  will  be  found  in  nearly  every  concern  some 
device  adopted  by  the  individual  bookkeepers  for  balanc- 
ing their  ledgers.  This  is  usually  in  the  shape  of  a  large 
"proof-sheet,"  on  which  are  recorded  the  totals  of  the 
various  books  or  columns  from  which  the  details  were 
posted.  Where  there  are  a  number  of  ledgers,  each 
dependent  upon  all  the  others  for  its  balance,  even  such 
a  makeshift  is  helpful  in  locating  the  ledger  that  is  out  of 
balance. 

But  a  much  more  practical  and  a  more  scientific 
method  employs  in  the  general  ledger  a  controlUng 
account  with  each  subsidiary  ledger.  From  the  various 
books  of  original  record  the  details  are  posted  to  the 
subsidiary  ledgers,  but  the  totals  are  posted  to  the  respec- 
tive controlling  accounts  in  the  general  ledger,  keeping 
that  ledger  in  balance.  For  instance,  there  may  be  two 
sales  ledgers  (A-M  and  N-Z)  to  which  the  details  of  the 
sales  book  are  posted.  In  the  general  ledger  ''Sales" 
account  would  be  credited  as  usual,  but  in  addition  each 
of  the  sales  ledger  controlling  accounts  would  be  debited 
with  its  part  of  the  total  sales. 

Ledger  A-M  Controlling  Account ,     $ 

Ledger  N-Z  Controlling  Account 

To  Sales  Account $ 

Columnar  Ledgers 

Another  form  of  ledger,  to  which  the  term  "self- 
balancing"  is  fully  as  applicable,  is  the  columnar  ledger. 
Its  advantage  lies  in  the  fact  that  a  large  number  of 
customers  or  accounts  can  be  carried  in  a  comparatively 
small  space  and  can  be  referred  to  with  a  minimum  of 
efifort.  It  can  be  used,  however,  only  when  the  number  of 
transactions  with  each  customer  is  small. 


THE    DETAILED    AUDIT  399 

The  ledger  gives  a  line  or  a  double  line  to  each 
account  and  provides  columns  for  posting  the  debits  and 
the  credits  once  each  month  or  at  other  intervals.  The 
totals  in  each  column  are  carried  forward  from  page  to 
page  or  are  recapitulated,  and  the  final  totals  should  agree 
with  the  totals  in  the  controUing  accounts  in  the  general 
ledger. 

Another  use  of  the  tabular  ledger  is  as  a  summary  of 
charges  where  customers  have  a  very  large  number  of 
transactions  monthly.  The  details  are  kept  in  a  subsi- 
diary ledger  and  are  posted  in  total  to  the  tabular  ledger. 
It  then  becomes  a  ledger  of  controlling  accounts,  and  is 
in  turn  controlled  by  an  account  in  the  general  ledger. 

Efficiency  of  Organization 

An  auditor  is  peculiarly  fitted,  upon  the  completion 
of  an  audit,  to  comment  intelligently  upon  the  efficiency 
of  the  organization.  He  has  had  access  to  all  the  records 
and  has  seen  the  performance  of  the  stafif  under  a  variety 
of  conditions.  The  average  client  today  wants  sugges- 
tions relative  to  the  perfection  of  his  organization,  and  it 
is  only  right  that  he  should  have  them.  The  auditor 
should  be  able  to  judge  whether  the  stafT  is  too  large, 
whether  the  arrangement  of  the  office  and  the  layout  of 
the  work  is  capable  of  improvement,  and  whether  there 
is  needless  repetition  of  records  in  different  departments. 

Many  times  it  is  possible  to  show  lazine&s  or  pure 
inability  on  the  part  of  employees  by  the  application  of  the 
efficiency  theory  that  for  any  task  there  is  a  determinable 
standard.  Suppose  it  had  been  demonstrated  that  a  clerk 
under  favorable  conditions  should  be  able  to  post  three 
hundred  items  per  day.  A  little  investigation  shows  that 
because  of  the  use  of  the  old-fashioned  index  and  awkward 
books  he  is  able  to  post  but  two  hundred  items,  therefore 


400  AUDITING 

the  work  is  only  66^  per  cent  efficient.  The  book  of 
original  entry  is  being  used  by  two  people,  so  he  has  to 
lose  10  per  cent  of  the  time  waiting  for  it.  That  brings 
the  efficiency  of  the  work  down  to  only  90  per  cent  of 
Q^Ys  per  cent,  or  60  per  cent.  He  is  fifteen  minutes 
late  in  the  morning,  begins  to  put  his  books  away  fifteen 
minutes  before  closing  time  at  night,  and  reads  the  paper 
for  half  an  hour  after  lunch.  Another  12%  per  cent  of 
the  Q^ys  per  cent  is  gone!  His  efficiency,  then,  would 
be  51^4  per  cent.  But  he  has  so  little  faith  in  the 
accuracy  of  his  work  that  he  checks  every  posting  back  to 
the  original  record,  losing  at  least  one-third  of  the 
possible  100  per  cent,  and  bringing  his  net  efficiency  to 
18  per  cent. 

If  he  were  paid  $18  per  week  and  another  man  were 
obtained  who  could  perform  the  work  according  to  the 
standard  set,  or  100  per  cent,  it  would  be  profitable  to 
pay  the  efficient  man  even  $50  per  week  and  still  receive 
from  him  twice  the  service  value  of  the  inefficient  man. 


CHAPTER    XVIII 

DEPRECIATION 

With  the  modern  development  of  business  and 
industry  and  the  enormous  additions  to  the  value  of 
property,  plant,  appliances,  and  stock  in  trade,  the  ques- 
tion of  depreciation  or  allowance  for  loss  of  value  has 
naturally  gained  much  in  importance. 

Indeed,  the  settlement  of  the  question  of  what  shall  be 
allowed  for  depreciation  is  one  of  the  most  important 
which  accountants  are  called  upon  to  discuss.  The 
auditor  must  always  consider  the  adequacy  or  inadequacy 
of  the  provision  made,  before  he  can  determine  the  form 
of  the  certificate  or  report  which  he  can  give. 

It  is  important  at  the  outset  to  distinguish  between 
fluctuation  and  depreciation.  The  former  may  be  a 
change  for  the  better  or  the  worse  in  the  value  of  the 
assets  and  is  attributable  to  causes  apart  from  the  business 
itself.  Entirely  extraneous  influences  may  cause  fluctua- 
tion in  the  value  of  assets  and,  therefore,  it  is  generally 
admitted  that  as  the  actual  manufacturing  profits  are 
not  afifected  thereby  one  way  or  the  other,  these 
fluctuations  in  value  need  not  be  considered  in  the  current 
accounts. 

Depreciation,  however,  is  a  decline  in  the  value  of 
property  such'  as  may  reasonably  be  expected  to  occur  as 
a  result  of  wear  and  tear  and  gradual  obsolescence.  It  is 
due  to  the  possession  and  use  of  the  assets,  and  therefore 

401 


402  AUDITING 

is  a  part  of  the  cost  of  operation.  A  concise  definition  of 
depreciation  which  has  been  widely  used  is  that  it  is  the 
deterioration  of  anything  by  time  or  use.  P.  D.  Leake's 
definition,  "expired  outlay  upon  productive  plant,"  is  a 
good  one,  as  is  also  "accrued  renewals." 

Before  leaving  the  subject  of  fluctuation  it  may  be  well 
to  consider  for  a  moment  what  treatment  may  be 
accorded  to  a  favorable  fluctuation  in  the  value  of  fixed 
assets  and  current  assets.  In  the  former  case  it  is  gen- 
erally conceded  that  the  increase  may  be  treated  as  a 
secret  reserve.  In  the  latter  case  it  is  temporarily  a  secret 
reserve  which  will  be  included  in  trading  profits  when  the 
assets  afiFected  are  realized.  An  unfavorable  fluctuation, 
if  apparently  of  a  temporary  character,  may  be  disre- 
garded, but  when  it  is  probable  that  the  unfavorable 
conditions  will  remain  until  the  time  of  realization  of  the 
assets  afifected,  provision  should  be  made  for  the  loss; 
in  other  words,  an  unfavorable  fluctuation  should  be 
charged  against  the  period  in  which  it  occurred  (as 
an  extraordinary  item)  instead  of  against  the  period  of 
realization. 

In  general  it  is  not  necessary  from  a  legal  standpoint 
to  charge  an  unfavorable  fluctuation  in  fixed  assets 
against  revenue  before  the  declaration  of  dividends  from 
current  profits.  While  these  fluctuations  may  be  disre- 
garded in  accounts,  it  may  be  desirable,  however,  to 
present  the  true  state  of  affairs  to  stockholders  by  means 
of  a  note  attached  to  the  balance  sheet  or  included  in  the 
auditor's  report. 

The  New  York  Court  of  Appeals,  in  one  of  its 
decisions,  stated  the  theory  of  a  depreciation  reserve  in 
a  most  lucid  manner,  as  follows: 

Judicial  notice  may  be  taken  of  the  fact  that  in  the  conduct  of  many 
industrial  enterprises  there  is  a  constant  deterioration  of  the  plant  which 


DEPRECIATION 


403 


is  not  made  good  by  ordinary  repairs  and  which,  of  course,  operates 
continually  to  lessen  the  value  of  the  tangible  property  which  it  aflfects. 
The  amount  of  this  depreciation  differs  in  different  enterprises,  but 
the  annual  rate  is  usually  capable  of  estimate  and  proof  by  skilled 
witnesses.  No  corporation  would  be  regarded  as  well  conducted  which 
did  not  make  some  provision  for  the  necessity  of  ultimately  replacing 
the  property  thus  suffering  deterioration ;  and  we  cannot  see  why  an 
allowance  for  this  purpose  should  not  be  made  out  of  the  gross  earn- 
ings in  order  to  ascertain  the  true  earning  capacity. 

Although  the  charge  for  depreciation  is  recognized  by 
the  law,  and  provision  is  made  therefor  in  the  forms 
supplied  by  the  Treasury  Department  in  connection  with 
the  Federal  Income  Tax  Law,  there  is  a  wide  difference 
of  opinion  as  to  the  amount  of  the  allowance  to  be  made 
from  time  to  time.  Many  company  officials — particularly 
railway  officials — prefer  to  regard  depreciation  charges  as 
flexible.  They  adjust  them  to  meet  the  conditions  of 
different  years,  so  that  in  time  of  large  profits  the  allow- 
ance shall  be  large,  and  during  bad  years  the  allowance 
small,  or  none. 

This,  however,  is  entirely  opposed  to  sound  account- 
ing principles,  and  the  Treasury  Department  in  this 
instance  agrees  with  the  opinion  of  the  accounting 
profession.  It  is  important  that  there  should  be  some 
fixity  in  regard  to  the  rate  of  depreciation  to  be  allowed. 
Under  the  system  of  varying  charges  for  depreciation  it 
would  be  impossible  to  fix  an  intelligent  basis  of  rates, 
and  comparisons  with  other  years  would  be  practically 
worthless.  If  the  business  man,  whether  in  the  railroad 
world  or  elsewhere,  is  to  pass  over  one  year  without 
making  any  allowance  for  depreciation,  it  will  result  in  a 
misrepresentation  of  conditions  at  the  end  of  that  year, 
and  it  is  unjust  and  incorrect  in  every  way  to  expect  a 
good  year  to  bear  the  burden  of  depreciation  which  has 
occurred  in  one  or  more  bad  years. 


404  AUDITING 

Causes  for  Depreciation 

The  various  elements  of  depreciation  have  been  very 
clearly  described  by  Professor  M.  E.  Cooley: 

1.  Depreciation  Due  to  Wear  and  Tear  and  Exposure  to  tfie  Ele- 
ments. This  is  continuous.  All  elements  have  a  wearing  life  varying 
with  the  element  itself.  No  element  can  be  completely  worn  out;  it 
can  be  worn  only  to  a  point  below  which  it  becomes  unsafe  or  no 
longer  serves  its  original  function.  In  practice  the  average  condition 
of  all  elements  must  be  maintained  at  a  high  percentage  of  the  original 
cost  if  the  property  is  to  serve  its  purpose  properly.  This  percentage 
varies  from  75  per  cent  to  85  per  cent  of  the  cost  new  of  the  property. 
The  difference  between  this  percentage  of  from  75  to  85  and  the  original 
100  is  a  depreciation  which  is  inherent  in  the  property  and  cannot  be 
dispensed  with.  It  must  be  met  by  a  sinking  fund,  or  its  equivalent, 
otherwise  this  part  of  the  original  investment  becomes  lost. 

2.  Depreciation  Due  to  Accidents;  a  Sudden  Depreciation.  An 
engine  or  a  boiler  may  be  wrecked,  and  with  it,  other  machinery.  This 
might,  and  probably  would,  involve  a  considerable  expense  for  repairs 
or  replacement  besides  possibly  crippling  the  plant  in  part.  Cars  may 
collide  or  a  car  may  drop  through  a  bridge.  A  bridge  itself  may  fall 
or  be  carried  away  by  floods.  A  storm,  as  a  cyclone,  may  work  havoc, 
entailing  costs  in  excess  of  those  proper  to  be  charged  to  ordinary 
maintenance  of  property. 

3.  Depreciation  Due  to  Inadequacy.  Cars  suitable  in  the  past  had 
already  been  superseded  several  times  by  larger  and  better  cars.  This 
has  rendered  the  track,  structure,  and  bridges  inadequate,  and  as  more 
power  is  required  to  propel  the  larger  cars,  the  power  plants  have  be- 
come inadequate.  The  public  demand  is  largely  responsible  for  this 
depreciation  due  to  inadequacy. 

4.  Depreciation  Due  to  Obsolescence.  This,  while  closely  allied  to 
the  depreciation  due  to  inadequacy,  is  different  in  that  it  embraces 
changes  due  to  advance  in  the  art.  More  efficient  and  effective 
machinery  has  appeared  which  must  be  substituted  for  the  old  to  keep 
abreast  of  the  times.  For  example,  in  steam-engine  practice  the  turbine 
has  come  into  general  use  during  the  past  five  years  and  the  art  of 
steam  turbines  is  at  the  beginning.  Generators  adapted  to  piston-engine 
practice  are  not  adapted  to  steam-turbine  practice  and  must  also  be 
changed.  Boilers  adapted  to  piston-engine  practice  must  be  replaced 
to  carry  the  higher  pressures  required.  Condensers  must  also  be 
changed  to  secure  the  better  vacuum  required  to  realize  the  full  advan- 
tage of  the  steam  turbine.  Owing  to  the  rapid  disappearance  of  coal 
beds,  the  price  of  fuel  must  advance,  and  this  presumably  will  before 


DEPRECIATION  405 

many  years  force  the  adoption  of  the  gas  producer  and  the  producer  gas 
engine.  Water  powers  are  wisely  being  developed,  but  to  utilize  them 
requires  the  scrapping  of  large  parts  of  the  machinery  in  use  at  present. 

Repairs  and  Maintenance 

It  is  an  accepted  rule  that  repairs  and  all  other 
expenses  of  maintenance  should  be  charged  against  profit 
and  loss.  An  exception  is  found  to  this  rule  in  cases 
where  partially  worn-out  or  run-down  plants  are  purchased 
with  the  intention  on  the  part  of  the  new  owners  to 
rehabilitate  them  so  that  they  can  be  operated  efificiently. 
It  can  be  assumed  that  the  purchase  price  takes  the  poor 
condition  of  the  plant  into  consideration,  in  which  case 
the  entire  cost  of  the  repairs  and  renewals  can  be  capitalized. 

The  auditor  should  not  decide  on  the  amount  required 
for  depreciation  until  he  has  scrutinized  the  repairs 
account,  as  in  this  account  he  may  find  that  charges  have 
been  made  for  renewals  and  replacements  which,  as  far  as 
they  go,  apply  in  lieu  of  a  depreciation  reserve. 

If  a  machine  could  be  built  like  the  *'one-hoss  shay," 
this  question  would  not  arise  and  a  depreciation  reserve 
would  work  out  exactly,  but  under  modern  conditions  it 
invariably  happens  that  a  machine  wears  out  one  part  at 
a  time,  and  if  the  parts  are  replaceable,  the  Hfe  of  the 
machine  as  a  whole  may  be  extended  almost  indefinitely. 
Obsolescence  and  inadequacy  are  the  practical  factors 
which  operate  against  a  fair  test  of  the  possible  life  of 
present-day  plant  and  equipment. 

Henry  Floy,  the  eminent  engineer,  cites  the  following 
instance: 

For  example,  the  life  of  the  ordinary  steam  engine  may  be  taken  at 
twenty  years,  but  it  is  not  uncommon  to  find  engines  still  in  use  that 
are  very  much  older  than  this.  The  writer  noted,  within  a  few  months, 
that  a  vertical  engine  installed  in  England  in  1856  had  recently  been 
equipped  with  condenser,  supplied  with  superheated  steam,  and  was  still 


4o6 


AUDITING 


in  use  at  fifty-five  years  of  age,  giving  economical   and  satisfactory 
results. 

Methods  of  Applying  Depreciation  in  the  Books 

The  following  table  shows  the  results  of  different 
methods  of  calculating  depreciation  over  a  period  of  ten 
years  upon  an  article  costing  $1,000  with  a  break-up  value 
of  $100  at  the  close  of  the  decade: 


Fixed    Percentage 

Sinking  Fund 

Fixed   Percentage 

Method    20.57% 

Method.    At  6% 

Year 

Method.  10%  en 
Origmal  Value 

on  Diminishing 
Value 

Compound 
Interest 

I 

$90.00 

$205.70 

$71-55 

2 

90.00 

163.38 

71.55 

3 

90.00 

129.78 

71.55 

4 

90.00 

103.08 

71.55 

5 

90.00 

81.88 

71.55 

6 

90.00 

65.03 

71.55 

7 

90.00 

51.66 

71 -55 

8 

90.00 

41.03 

71.55 

9 

90.00 

32.59 

71.55 

lO 

90.00 

25.87 

71.55 

$715.50 

Compound  In- 

terest at  5%.. 

184.50 

Totals 

$900.00 

$900.00 

$900.00 

1.  The  Fixed  Percentage  Basis.  This  method  is  the 
most  popular  and  is  the  one  in  general  use.  It  is  applied  as 
follows : 

(a)  On  a  flat  basis,  e.g.,  if  the  Hfe  of  a  machine  is  ten 
years,  one-tenth,  or  10  per  cent,  is  charged  off  annually. 

(b)  On  a  reducing  scale  basis,  i.e.,  a  rate  is  ascertained 
which,  when  applied  to  the  original  cost  and  on  the 
diminished  value  thereof  as  periodically  determined,  will 
reduce  the  book  value  to  scrap  value  at  the  end  of  its 
estimated  life. 

Method  (a)  is  more  generally  followed  than  (b), 
although  there  is  in  use  a  method  which  is  a  cross  between 


DEPRECIATION  407 

the  two  and  which  is  not  scientific.  It  consists  in  charg- 
ing the  rate  as  determined  under  (a),  but  in  applying  it  to 
the  reducing  value  instead  of  to  the  original  cost.  For 
instance,  if  the  life  of  a  boiler  is  estimated  at  ten  years,  10 
per  cent  per  annum  is  set  aside,  but  on  the  diminishing 
value.  If  the  table  on  page  406  were  calculated  on  this  basis, 
the  book  value  would  be  $348.68  at  the  end  of  the  tenth 
year,  instead  of  $100  as  under  the  other  methods. 

Nevertheless,  this  is  a  popular  method  and  must  be 
reckoned  with.  The  fact  of  the  matter  is  that  when  an 
executive  directs  a  clerk  to  ''charge  ofif  10  per  cent  for 
depreciation,"  he  does  not  stop  to  consider  whether  it 
means  of  the  original  cost  or  the  reduced  value. 

The  theory  of  and  advantage  claimed  for  (b)  is  that 
repairs  and  maintenance  are  very  light  during  the  early 
years  of  a  machine  and  very  heavy  during  the  later  years. 
In  both  (a)  and  (b)  it  is  contemplated  that  all  mainten- 
ance costs  are  to  be  charged  ofif  in  addition  to  the 
depreciation. 

Roughly  speaking,  with  (b)  the  aggregate  of  deprecia- 
tion and  maintenance  would  be  the  same  each  year, 
whereas  under  (a)  the  aggregate  during  the  first  years 
would  be  light  and  during  the  last  years  heavy. 

2.  Sinking  Fund  Method.  If  it  is  proposed  to  set 
aside  such  a  sum  periodically  as  will  equal  the  original 
cost  of  a  machine  (less  scrap  value)  at  the  end  of  its 
estimated  life,  it  is  customary,  after  taking  into  consid- 
eration the  average  rate  of  interest  which  can  be  secured, 
to  pay  into  a  fund  a  fixed  amount  periodically.  The 
aggregate  thereof,  together  with  the  accumulated 
interest,  will  equal  the  amount  required  to  renew  the 
machine  in  question.    This  method  is  seldom  followed. 

There  is  good  authority,  however,  for  its  use  where 
a  single  large  piece  of  property  is  being  operated. 


4o8  AUDITING 

This  point  is  well  expressed  by  Mr.  Floy: 

In  all  cases  involving  a  consideration  of  the  expenses  of  keeping  a 
property  in  operation,  there  should  invariably  be  included  allowances  to 
cover  all  ultimate  depreciation  and  replacement.  For  a  small  company 
or  where  relatively  large  proportions  of  the  invested  capital  are  locked 
up  in  a  few  or  single  pieces  of  property,  it  is  preferable  to  accumulate, 
in  advance  out  of  operating  income,  reserve  funds  from  which  to  pro- 
vide for  all  classes  of  depreciation.  But  such  method  may  be  unneces- 
sary and  possibly  an  inexpedient  accounting  complexity  with  large  cor- 
porations, where  the  investments  in  any  single  piece  of  physical  prop- 
erty are  small,  relative  to  the  total  investment.  The  truth  of  the  above 
will  be  at  once  recognized  from  the  following  illustration.  If  the  com- 
pany which  erected  the  Metropolitan  Life  Insurance  building  had  only 
that  property,  it  would  be  essential  that  funds  should  be  laid  aside 
annually  in  amounts  sufficient  to  replace  the  original  investment  at  the 
end  of  the  useful  life  of  said  building. 

The  conflict  between  the  Third  Avenue  Railway  Com- 
pany and  the  New  York  Public  Service  Commission  with 
reference  to  the  actual  setting  aside  of  an  amortization 
fund  and  a  depreciation  fund  is  of  considerable  interest. 
The  Third  Avenue  Railway  Company  had  gone  through 
a  receivership  and  the  par  value  of  the  securities  of  the 
reorganized  company  exceeded  by  a  considerable  amount 
the  value  of  the  physical  property  owned  by  the  company. 
The  Commission  directed  that  a  fund  be  created  into 
which  the  Company  pay  annual  instalments  out  of  its 
income,  so  that  at  maturity  of  the  outstanding  securities 
an  amount  would  have  been  accumulated  which,  together 
with  the  company's  other  property,  would  equal  the  par 
value  of  the  outstanding  securities. 

The  Commission  also  directed  that  there  be  set  aside 
annually  at  least  20  per  cent  of  the  earnings  for  current 
maintenance  and  future  replacements  (depreciation),  the^ 
unexpended  portion  of  this  amount  to  be  "credited"  to  a 
separate  depreciation  fund  at  the  end  of  each  year. 

The  opinion  of  the  Comxmission  is  of  sufficient  impor- 


DEPliECIATION  409 

tance  and  interest  to  warrant  the  reproduction  in  full  of 
that  part  deahng  particularly  with  the  amortization  and 
depreciation  funds. 

Amortization  of  Discounts.  The  requirement  that  discounts  shall 
be  amortized  is  a  generally  recognized  principle.  The  unanimous  con- 
clusion of  the  Railroad  Securities  Commission  in  its  recent  report  to 
the  President  of  the  United  States  was  to  this  effect:  "It  seems  to  be 
generally  agreed  that  no  limitation  should  be  placed  on  the  price  at 
which  bonds  can  be  sold,  but  any  discount  should  be  canceled  or 
amortized  during  the  life  of  the  bonds  by  the  appropriation  each  year 
out  of  annual  income  or  surplus  accumulated  after  the  issue  of  the 
bonds  of  not  less  than  the  proportionate  amount  of  the  discount."  The 
Securities  Commission  also  said,  regarding  the  issue  of  stock  below  par, 
that  the  difference  between  par  value  and  cash  received  should  be 
amortized  within  a  short  term  of  years,  thus : 

If  a  document  says  one  hundred  dollars  has  been  paid,  one  hundred 
dollars  ought  to  be  paid.  The  most  that  can  properly  be  done  is  to 
allow  companies  which  cannot  sell  such  stock  at  par  to  arrange  for  the 
"amortization,"  or  gradual  cancellation,  of  any  necessary  discount  by 
appropriating,  out  of  future  income  or  surplus  which  may  accrue  sub- 
sequent to  the  issue  of  such  stock  an  annual  sum  having  precedence 
over  dividend-payment,  to  be  so  applied  on  capital  account  as  to  make 
the  deficiency  good  in  a  period  of  no  very  great  length. 

In  order  that  this  difference,  which  Is  in  the  nature  of  a  discount 
upon  securities,  may  be  eliminated  during  the  life  of  the  bonds,  it  is 
necessary  that  an  amount  should  be  set  aside  annually  out  of  income 
before  dividends  and  interest  on  the  income  bonds  may  properly  be 
paid.  It  is  evident  that  the  annual  amount  is  determined  by  the  rate 
at  which  the  fund  will  accumulate.  It  is  certainly  not  less  than  4  per 
cent,  and  upon  this  basis  the  annual  payment  would  be  $180,000,  plus  4 
per  cent  upon  previous  payments  and  accumulations.  If  this  course  is 
followed,  the  company  in  1960  will  have  a  fund  which,  together  with  its 
other  property,  assuming  it  to  be  maintained  as  above  stated,  will  be 
equivalent  to  the  par  value  of  the  securities  then  outstanding. 

It  is  apparent  that  if  the  company  is  able  to  earn  only  4  per  cent 
upon  this  fund,  either  through  investments  in  securities  or  in  its  own 
property,  the  net  deduction  will  be  $180,000  per  annum.  If,  however, 
the  company  is  able  to  earn  even  more  than  4  per  cent  per  annum,  the 
income  above  4  per  cent  will  work  to  reduce  the  net  annual  charge 
against  income  by  the  precise  amount  which  the  actual  earnings  exceed 
4  per  cent.  If,  for  example,  the  company  should  be  able  to  earn  6 
per  cent  per  annum,  the  net  amount  would  be  less  than  $100,000. 


410 


AtDITING 


Unless  some  such  plan  is  followed,  the  company  will  not  be  able  in 
1960,  in  refunding  the  bonds  then  due,  to  present  as  the  basis  for  such 
refunding  property  which  is  equal  to  the  par  value  of  the  securities. 
They  will  be  represented  in  part  by  discounts  upon  issues  of  1912,  fifty 
years  before. 

Depreciation.  The  foregoing  requirement  has  reference  only  to  the 
present  impairment  of  capital.  This  impairment  of  capital  has  resulted 
to  a  considerable  extent  from  the  neglect  of  the  old  company  to  make 
proper  provision  for  depreciation.  If  the  company  does  not  reserve  a 
sufficient  portion  of  its  revenue  to  replace  capital  consumed  during  the 
year  but  not  requiring  replacement  within  the  year,  and  then  proceeds 
to  treat  the  entire  surplus  as  divisible  profits,  it  is  actually  violating  the 
corporation  law  against  the  declaration  of  dividends  out  of  capital  just 
as  effectually  as  though  it  sold  stock  and  distributed  the  proceeds 
immediately  in  the  form  of  dividends.  Unless,  therefore,  careful  pro- 
vision is  made  for  the  creation  of  a  depreciation  reserve,  there  may  be 
another  repetition  of  the  financial  collapses  that  have  been  so  con- 
spicuous in  the  history  of  the  street  railways  in  Manhattan. 

Under  the'  Third  Article  of  the  first  refunding  mortgage  and  the 
Fifth  Article  of  the  income  mortgage,  the  company  agrees  and  cove- 
nants to  maintain  property  by  making  needful  repairs,  renewals,  and 
replacements,  and  under  the  Second  Article  of  the  refunding  mortgage 
it  further  agrees  that  no  bonds  shall  be  issued  for  replacements  or 
operating  expenses.  To  provide  for  such  replacements,  however,  there 
ought  to  be  some  definite  provision  for  a  depreciation  reserve.  The 
matter  assumes  a  special  importance  in  view  of  the  fact  that  the  declara- 
tion of  interest  upon  the  income  bonds  will  depend  upon  a  precise 
definition  of  expenses  and  other  deductions  that  may  be  made  from 
revenue.  Without  clear  definitions  there  is  an  almost  certain  likelihood 
of  disputes  between  the  income  bondholders  and  the  stockholders  as  to 
the  true  amount  of  the  profits.  The  Second  Article,  Sub.  a,  of  the  in- 
come mortgage  enumerates  the  various  items  of  expense  to  be  deducted 
from  revenue  and  specifies  depreciation  or  obsolescence,  but  leaves  the 
amount  of  such  charge  to  be  determined  entirely  by  the  discretion  of 
the  Board  of  Directors.  When  it  is  recalled  that  in  one  case  where  it 
was  the  object  of  the  company  to  show  small  earnings  Receiver  Whit- 
ridge  testified  before  the  Commission  that  the  total  annual  depreciation 
amounted  to  $600,000,  and  that  in  a. second  case,  where  it  was  the  object 
of  the  company  to  show  large  earnings,  the  same  Receiver  testified  that 
depreciation  amounted  only  to  $300,000,  one  will  realize  the  necessity  of 
a  more  specific  definition  of  depreciation. 

In  the  opinion  of  the  Commission,  there  should  be  reserved  out  of 
revenue  for  the  upkeep  of  the  property,  including  both  current  main- 
tenance and  future  replacements,  in  accordance   with   the  accounting 


DEPRECIATION  4II 

rules  of  the  Commission,  at  least  20  per  cent  of  the  operating  revenue 
of  the  Third  Avenue  Railway.  This  minimum  rate  has  been  used  in 
other  mortgages  and  contracts,  is  practically  the  standard  percentage 
used  by  engineers  in  appraising  street  railways,  and  more  especially  is 
the  rate  estimated  by  the  Chairman  of  the  Reorganization  Committee 
of  the  Metropolitan  Street  Railway  Company. 

The  Commission  does  not  fix  20  per  cent  as  the  maximum  rate  or 
as  the  rate  applicable  to  all  cases.  Further,  if  this  rate  should  prove  to 
be  too  high  after  a  number  of  years,  the  facts  may  be  presented  upon 
application  to  the  Commission  for  a  modification  of  this  order. 

3.  Production  Method.  A  method  of  making  depre- 
ciation allowances  which  has  its  advantages  under  certain 
conditions  is  that  of  charging  an  established  rate  per  unit 
of  output.  This  is  especially  applicable  in  the  case  of,  say, 
a  blast  furnace  where  the  frequency  with  which  the  linings 
will  need  to  be  renewed  depends  on  the  extent  to  which 
the  furnace  is  being  used.  If  it  is  being  run  at  full 
capacity  night  and  day,  the  wear  on  the  linings  is 
obviously  much  greater  than  if  the  furnace  had  not  been 
in  continual  use  during  the  entire  fiscal  period. 

Another  species  of  depreciation  which  may  be  s^id  to 
come  under  the  above  caption  is  that  caused  in  a  plant  by  the 
exhaustion  of  the  mines  or  timber  lands  in  connection 
with  which  the  plant  was  constructed.  Most  of  the  value 
of  coke  ovens,  for  instance,  is  gone  when  the  mines  for 
which  they  were  constructed  are  worked  out.  Conse- 
quently, in  determining  the  amount  to  be  written  off  for 
depreciation  of  mining  and  lumbering  plants,  the  factor 
of  the  probable  future  output  of  the  mines  or  lands  will 
be  an  important  one  and  it  will  frequently  be  found  advis- 
able to  base  the  plant  depreciation  charge  on  the  output. 
Certainly  this  should  be  done  where  it  is  evident  that  the 
plant  will  outlive  the  exhaustion  of  the  mines  or  lands. 
In  such  cases  the  depreciation  charges  should  be  sufficient 
to  absorb  the  entire  cost  of  the  plant,  less  residual  value, 
by   the   time   the   mines   or  lands  are   exhausted,   even 


412  AUDITING 

though  at   that  time  the  plant   might   still  be  in  good 
operating  condition. 

Sinking  Fund  Requirements  to  Retire  Bonds,   etc.,  Must 
Not  be  Confused  with  Depreciation  Allowances 

The  trained  accountant  or  engineer  recognizes  the 
distinction  between  depreciation  and  sinking  funds  and 
never  confuses  the  two  terms.  Not  so,  however,  with 
lawyers  and  business  men.  The  modern  industrial  bond  is 
not  popular  unless  a  provision  is  inserted  in  the  trust  deed 
requiring  that  a  sufficient  sum  be  set  aside  annually,  or 
otherwise,  to  retire  the  bonds  before  or  at  maturity. 

It  is  usual  to  provide  that  the  instalments  must  be 
provided  out  of  earnings,  and  this  is  a  wise  course  to 
follow,  as  it  serves  to  keep  down  dividend  declarations 
during  the  life  of  the  bonds.  Nevertheless,  the  sinking 
fund  instalments  are  capital  expenditure  and  do  not  prop- 
erly appear  among  operating  expenses,  but  should  be 
stated  as  deductions  from  the  net  profits  when 
ascertained.  This  course  fulfils  the  obligation  imposed 
in  the  trust  deed  and  yet  does  not  permit  the  surplus  to 
be  overstated. 

Now  the  sinking  fund  provision  may  be  greater  or  less 
than  the  amount  required  for  depreciation,  aside  from  the 
fact  that  one  is  an  operating  expense  and  the  other  is  a 
discharge  of  a  capital  obligation.  Therefore,  depreciation 
should  be  calculated  and  charged  against  earnings  before 
the  net  profit  is  determined  irrespective  of  the  existence 
or  non-existence  of  sinking  fund  requirements. 

The  common  misconception  of  the  proper  treatment  of 
compulsory  sinking  funds  can  be  explained  by  an  illustra- 
tion taken  from  actual  practice.  A  manufacturing 
corporation  handling  a  patented  device  issued  bonds 
aggregating  $375,000,  payable  in  instalments  of  $25,000 


DEPRECIATION  413 

annually  for  fifteen  years.  Having  in  mind  possible  com- 
petition and  obsolescence  of  its  property,  it  was  provided 
that  the  sinking  fund  instalments  be  charged  against 
earnings.  The  president  of  the  company  had  a  contract 
under  which  he  was  to  receive  a  bonus  of  5  per  cent  of  the 
net  profits  in  addition  to  his  salary,  but  it  was  specifically 
provided  that  as  to  him  the  charges  against  earnings 
should  not  include  the  sinking  fund  instalments.  In 
making  up  the  first  year's  accounts  the  auditors  decided 
that  the  depreciation  reserve,  as  nearly  as  could  be  deter- 
mined, should  be  stated  as  $25,000,  and  this  amount  was 
included  among  the  operating  expenses. 

When  their  report  was  submitted  to  the  directors,  the 
president  referred  to  his  contract  and  stated  that  the 
sinking  fund  provision  and  depreciation  were  synonymous 
and  that  he  was  entitled  to  5  per  cent  of  the  earnings 
before  any  deduction  was  made  for  depreciation.  The 
majority  of  the  directors  agreed  with  him,  with  the  result 
that  the  company  has  overpaid  the  president  $1,250  per 
annum  for  several  years. 

Perhaps  the  time  will  arrive  when  depreciation  will  be 
generally  considered  as  a  prime  operating  cost.  If  it  is 
so  treated  throughout  the  accounts,  no  such  misunder- 
standing as  that  above  cited  could  occur. 

Depreciation  Is  an  Operating  Expense 

We  often  see  a  statement  in  published  reports  that  a 
corporation  has  realized  net  profits  amounting  to  a 
certain  sum,  and  that  out  of  these  profits  an  allowance  for 
depreciation  has  been  made.  It  would  be  just  as  logical 
to  state  that  a  candy  manufacturer  had  earned  a  net  profit 
of  $100,000  and  that  out  of  said  $100,000  there  had  been 
set  aside  $20,000  to  pay  for  the  sugar  consumed  in  the 
manufacture  of  the  product. 


4IJ.  AUDITING 

The  use  of  that  which  is  consumed  is  a  loss  or  expense. 
Machinery  is  consumed;  sugar  is  consumed.  You  cannot 
say  that  one  is  an  operating  expense  and  the  other  is  an 
item  which  need  not  be  ascertained  nor  taken  into  account 
until  the  net  profit  is  shown.  Net  profit  means  only  one 
thing  in  the  vocabulary  of  the  professional  auditor,  and 
that  is  the  excess  of  income  over  operating  costs,  expenses, 
and  losses.  It  cannot  be  determined  by  taking  into 
account  all  of  the  income  and  a  part  only  of  the  charges 
against  income.  If  the  provision  for  depreciation  is  not 
such  an  item  as  can  be  included  among  the  costs  of  opera- 
tion, then  it  is  a  misnomer. 

This  view  of  depreciation  is  well  expressed  by  Professor 
Henry  C.  Adams,  writing  with  respect  to  railroad 
accounts,  but  the  principle  enunciated  applies  with  equal 
force  to  industrial  accounts. 

When  carried  to  its  final  analysis  the  question  of  formal  deprecia- 
tion charges  to  operating  expenses  is  simply  a  question  of  what  con- 
stitutes cost  of  operation,  and  the  time  when  such  cost  shall  be  acknowl- 
edged in  the  accounts.  The  position  which  the  Interstate  Commerce 
Commission's  system  of  accounts  assumes  on  this  point  is,  that  the 
depletion  of  an  asset  which  represents  an  investment  through  the  use 
of  that  asset  in  operation  creates  an  item  of  cost  of  operation  which 
should  be  reflected  in  the  accounts  when  the  fact  of  such  depletion  takes 
place,  and  that  a  statement  of  net  revenue  made  without  including  this 
element  of  cost  in  operation  expenses  is  an  erroneous  statement. 

After  all,  the  problem  is  not  so  very  difficult.  It  re- 
quires little  additional  work  to  determine  the  depreciation 
for  each  shop  or  department,  and  to  apportion  this  each 
month  to  the  department  or  shop  to  which  it  belongs. 
If  thus  handled  in  detail  from  month  to  month,  deprecia- 
tion is  relieved  of  the  complication  of  attempting  to  cal- 
culate it  at  the  end  of  a  fiscal  year  on  the  plant  and  equip- 
ment as  a  whole. 


DEPRECIATION  ^jc 

Depreciation  a  Local  Issue 

The  auditor  must  use  his  own  judgment  in  passing  on 
rates  of  depreciation  just  as  much  as  he  does  when  he 
inspects  purchase  vouchers.  In  one  locality  steam  coal 
may  be  $2  a  ton;  in  another,  $4.  The  variation  may  be 
entirely  legitimate.  In  one  locality  boilers  may  depre- 
ciate 714  per  cent  annually,  in  another  the  rate  may  be 
15  per  cent. 

It  is  not  merely  a  question  of  the  life  of  the  boilers, 
because  no  experienced  engineer  or  boiler  manufacturer 
would  answer  the  question  unless  he  knew  the  use  to 
which  the  boiler  would  be  subjected,  the  climate,  the 
water,  the  class  of  labor,  the  probabilities  of  shut-downs, 
etc.  And  similarly  with  almost  all  other  classes  of  prop- 
erty which  depreciate  by  wear  and  tear.  Therefore,  wher- 
ever rates  of  depreciation  are  mentioned  in  this  chapter, 
they  must  be  taken  as  suggestive  only  and  in  a  relative 
sense.  The  student  without  other  experience  can  thus 
broadly  acquaint  himself  with  general  observations  and 
modify  his  views  later  on  as  he  gains  experience. 

Investment  of  Depreciation  Reserves 

It  has  been  urged  that  unless  an  amount  correspond- 
ing to  the  reserve  for  depreciation  is  invested  in  market- 
able securities,  it  is  not  a  de  facto  reserve,  but  merely  a 
book  account.  This  is  a  matter  of  secondary  importance. 
The  principal  point  to  consider  is  whether  or  not  there 
has  been  charged  to  income  a  sufficient  sum  to  cover  the 
loss  by  wear  and  tear  and  obsolescence.  So  long  as  this  is 
done  there  is  no  possibility  of  the  amount  thereof  being 
paid  out  in  dividends.  It  is  left  in  the  business  in  the  form 
of  cash  or  any  other  undivided  asset.  The  question  of 
its  investment  is  immaterial. 

The  concern  that   can  and  does  purchase  securities 


4i6 


AUDITING 


equal  to  its  depreciation  reserve  and  retain  such  securities 
until  the  proceeds  are  needed  for  the  purchase  of  machin- 
ery, etc.,  could  certainly  be  depended  upon  to  renew  its 
machinery  when  necessary  even  though  its  depreciation 
reserve  was  represented  among  its  current  or  fixed  assets. 
The  life  of  plant  and  equipment  is  too  uncertain  to 
warrant  the  purchase  of  bonds  which  are  to  be  sold  to 
finance  renewals.  A  well-managed  plant  is  attended  to 
daily  as  to  its  upkeep,  and  renewals  and  changes  are  made 
as  needed. 

Importance  of  Provision  for  Obsolescence 

It  has  been  pointed  out  that  actual  depreciation  is 
ascertainable.  That  is  to  say,  machinery,  for  instance, 
cannot  be  operated  efficiently  if  it  falls  below,  say,  70  per 
cent  of  its  condition  when  new.  If  its  theoretical  life  is 
ten  years  and  30  per  cent  has  been  set  aside  during  the 
first  three  years,  the  question  then  arises  as  to  what  to  do 
at  the  end  of  the  fourth  year.  If  the  shop  is  properly 
managed,  it  is  probable  that  the  machine  is  worth  YO  per 
cent  of  its  cost  and  will  remain  so  until  superseded.  But 
no  manufacturer  can  depend  on  keeping  up  his  equipment 
by  renewing  old  machines  in  whole  or  in  part.  It  is  in- 
evitable that  improvements  will  come  so  long  as  the  times 
produce  inventors  and  men  of  initiative.  Therefore  the 
manufacturer  who  is  willing  that  the  product  of  a  machine 
shall  bear  the  cost  of  the  machine  continues  to  charge 
operating  and  credit  reserve  for  depreciation  with  such  an 
amount  as  will  enable  him  to  discard  his  old  machine  as 
soon  as  a  better  one  appears. 

One  of  the  foremost  efficiency  engineers  in  this  coun- 
try told  the  author  that  the  tendency  to  scrap  old 
machines  and  buy  new  ones  had  often  been  carried  to  an 
extreme;  that  in  some  cases  a  new  machine  of  twice  the 


DEPRECIATION  417 

capacity  of  an  old  one  costs  much  more  than  twice  as 
much,  and  that  the  interest,  depreciation,  and  other 
charges  against  the  new  machine  more  than  offset  the 
saving  in  time  or  increase  in  production. 

Nevertheless,  the  tendency  to  discard  is  strong,  and 
the  auditor  who  endeavors  to  charge  out  the  cost  of  a 
machine  against  its  product  must  set  up  a  reserve  for 
obsolescence  or  he  will  find  the  reserve  for  depreciation 
insufficient. 

It  is  not  advisable  to  separate  the  accounts  in  the 
books  nor  on  financial  statements.  No  manufacturer  cares 
to  publish  his  estimate  of  that  part  of  his  equipment  which 
is  getting  out  of  date. 

Depreciation  of  Different  Classes  of  Property 

Passing  from  a  general  discussion  of  the  rules  which 
have  the  approval  of  competent  authorities,  it  is  desirable 
to  study  their  application  to  various  classes  of  assets.  For 
the  sake  of  convenience  we  will  take  up  the  depreciation 
of  fixed  assets  as  they  appear  elsewhere  in  this  book. 

Before  doing  so,  however,  it  will  be  of  interest  to  note 
the  variation  in  rates  which  apply  to  different  classes  of 
enterprises,  as  given  below.  This  schedule  was  compiled 
by  one  who  has  had  many  years  of  experience  in  apprais- 
ing property,  and  it  illustrates  the  futility  of  trying  to 
establish  uniform  rates. 

Textile  Industry.  The  depreciation  on  buildings  of  this  industry  is 
somewhat  heavier  than  on  others  owing  to  the  vibration  of  the 
machines.  Also  the  machinery  is  sometimes  given  a  heavy  depreciation 
owing  to  its  obsolescence  or  to  the  addition  of  new  appliances  added 
annually  in  the  interest  of  this  particular  business.  The  average  de- 
preciation would  be  about  3  per  cent  on  the  building  and  4  per  cent  on 
the  machinery. 

Printers.  The  depreciation  of  printing  plants  is  about  the  same  as 
that  of  the  textile  industry,  with  the  exception  of  type,  printers'  tools, 


4i8 


AUDITING 


electrotype,  plates,  etc.,  on  which  about  10  per  cent  or  12  per  cent  should 
be  applied  annually. 

Foundries.  The  depreciation  will  not  average  more  than  1^  per 
cent  on  foundry  buildings.  The  equipment,  with  the  exception  of  flasks, 
patterns,  and  core  boxes,  should  not  take  more  than  about  3  per  cent; 
while  on  the  flasks,  patterns,  and  core  boxes,  should  be  applied  about  10 
per  cent  or  20  per  cent  because  a  large  number  of  patterns  become 
obsolete  owing  to  the  fact  that  they  are  made  from  an  experimental 
standpoint. 

Chemical  Industry.  In  this  industry  the  buildings  depreciate  about 
\y2  per  cent  to  2  per  cent.  The  machinery  and  equipment  depreciation 
depends  strictly  upon  the'  nature  of  the  product  manufactured,  the 
average  being  about  15  per  cent. 

Laundries.  On  buildings  of  this  industry  the  rate  is  very  low.  The 
equipment  fluctuates  from  year  to  year.  The  average  depreciation  is  in 
the  neighborhood  of  about  8  per  cent. 

Hat  Manufacturers.  The  depreciation  on  buildings  is  about  V/i 
per  cent ;  on  equipment  about  4^^  per  cent ;  while  on  the  molds  con- 
nected with  this  business  depreciation  will  be  applied  in  the  same 
manner  as  on  the  patterns  in  a  foundry. 

Paper  Industry.  There  is  a  very  low  rate  on  the  buildings,  while 
the  equipment  should  not  go  over  3  per  cent  to  5  per  cent.  This  is  due 
to  the  fact  that  the  paper  industry  has  run  on  about  the  same  basis 
during  the  last  five  years  and  has  not  shown  any  vital  improvement  in 
manufacturing  methods. 

Soap  Industry.  Depreciation  in  this  industry  is  about  the  same  as 
in  chemical  factories. 

Wood-Working  Industry.  On  buildings  and  equipment  the  depre- 
ciation is  very  low— about  2  per  cent  or  3  per  cent  on  buildings  and  4 
per  cent  on  equipment. 

Land 

It  is  usual  to  dismiss  this  item  with  the  statement  that 
land  does  not  depreciate.  Nothing  could  be  further  from 
the  fact.  The  great  bulk  of  land  in  the  United  States  is 
depreciating  through  use  just  as  much  as  depreciation 
occurs  in  machinery  through  use. 

The  land  on  which  buildings  are  erected  or  which  is 
used  for  storage  purposes,  etc.,  may  not  depreciate,  and 
the  aggregate  of  such  holdings  is  very  large,  but  the 
auditor  must  inquire  into  the  purpose  for  which  land,  is 


DEPRECIATION 


419 


used,  its  location,  etc.,  before  he  can  decide  offhand  that 
the  land  has  not  depreciated. 

Land  used  for  agricultural  purposes  may  depreciate 
through  use  and  does  depreciate  unless  a  certain  rotation 
of  crops  is  followed  or  unless  fertilizers  are  used.  The 
latter  is  equivalent  to  the  cost  of  maintenance  and  repairs 
in  a  factory. 

The  price  of  flax  seed  has  increased  enormously  because 
during  the  early  years  of  farming  in  the  West  the  vitality 
of  the  land  was  exhausted  by  raising  a  crop  which  impov- 
erished the  soil  to  such  an  extent  that  the  farmers  were 
obliged  to  discontinue  the  raising  of  flax.  During  the 
period  when  this  crop  was  using  up  the  value  of  the  land 
the  farmers  should  have  set  up  a  reserve  for  depreciation, 
and  it  would  have  been  apparent  that  the  net  price  realized 
from  the  flax  crop  was  not  nearly  so  high  as  it  seemed, 
and  that  wheat,  while  bringing  in  less  cash  per  acre,  would 
have  been  more  profitable. 

This  illustration  may  not  seem  pertinent  enough  to 
warrant  its  inclusion  in  a  book  which  is  intended  to  be 
practical,  but  the  author  wishes  students  in  particular  to 
use  their  imagination  on  every  possible  occasion,  and  this 
is  a  convenient  place  to  reiterate  the  advice.  Heretofore 
text-books  on  auditing  have  stated  without  qualification 
that  land  does  not  depreciate.  If  it  is  a  fact  that  three- 
fourths  of  the  land  in  the  United  States  is  depreciating 
through  use,  these  statements  should  not  have  been  al- 
lowed to  go  unchallenged  so  long. 

Land  fluctuates  in  value,  sometimes  violently,  but  such 
variations  are  not  to  be  confused  with  depreciation. 

Buildings 

It  is  difficult  to  foretell  at  what  rate  buildings  will 
depreciate,  and  it  is  practically  impossible  to  set  a  stand- 


420  AUDITING 

ard  common  to  all  the  different  classes  of  buildings  which 
may  be  found  among  the  assets  of  different  enterprises. 
When  the  ledger  account  includes  land  with  buildings,  the 
depreciation  usually  must  be  confined  to  the  buildings 
only.  As  a  general  plan,  if  the  allowances  for  ileprecia- 
tion  take  the  form  of  the  instalment  plan,  the  annual  rate 
of  deduction  will  range  from  1  per  cent  to  5  per  cent  of 
the  original  amount,  the  rate  varying  according  to  the 
workmanship,  material,  service  to  which  the  building 
is  put,  climate,  and  any  other  factor  which  may  in- 
fluence the  life  of  the  building.  By  the  sinking  fund 
system  the  sum  to  be  set  aside  must  be  such  as  will 
accumulate  to  the  cost  of  the  building  during  the  prob- 
able Hfe  of  the  building.  Repairs  will  have  to  be. 
borne  by  the  income,  in  addition  to  the  item  of  depre- 
ciation. 

It  must  be  remembered  that  no  building  will  last  for- 
ever; and  this  statement  is  made  in  the  face  of  the  claims 
of  the  advocates  of  concrete  construction.  Possible  appre- 
ciation in  land  should  not  be  used  as  an  ofTset  against  the 
depreciation  of  buildings  unless  the  former  is  set  out 
clearly  on  the  income  side  of  the  accounts  and  the  charge 
for  depreciation  included  among  the  expenses.  It  will 
then  be  apparent  that  an  anticipated  profit  is  being  used 
to  offset  an  actual  expense. 

A  prominent  engineer  says  that  a  building  in  which 
rapidly  revolving  shafting  is  employed,  or  in  which  ma- 
chines operate  with  considerable  shock,  such  as  a  number 
of  drop  forge  hammers,  also  depreciates  rapidly;  and  for 
such  buildings  a  yearly  depreciation  of  from  4  per  cent  to 
8  per  cent  should  be  allowed. 

One  of  the  leading  appraisal  companies  states  that  in 
connection  with  concrete  buildings  not  more  than  two 
or  three  years  old,  it  is  sometimes  necessary  to  apply  a 


DEPRECIATION  ^21 

high  rate  of  depreciation  because  the  cement  mixtures 
used  were  not  in  accordance  with  first-class  practice. 

The  following  rates  of  depreciation  on  buildings  are 
taken  from  different  authorities. 

U.  S.  Government  Allowance:  Per  Cent  Per  Annum 

Brick  buildings:  Occupied  by  Owner 1      to      1J4 

"  "    Tenant \%    "       1J4 

Frame  buildings:       "  "    Owner 2       "      2^ 

"     Tenant 2^    "       3 

Wisconsin  Commissions :  Years  of  Life 

First-class  stone  and  brick  (office  buildings) 75 

Second-class  shops,  car-barns,  and  power  stations. ..  50 

Brick  gas-retort  houses 30 

Frame  dwellings 35 

Frame  stables  and  coal  sheds 20  to  25 

Public  Service  Commission,  New  York :                  Per  Cent  Per  Annum 
Brick   buildings 2 

Chicago  Traction  Co.  Valuation: 

Brick  buildings 1)^ 

Leaseholds 

Premiums  paid  for  leases  may  be  considered  as  the 
price  of  a  terminable  annuity  of  an  amount  equal  to  the 
difference  between  the  annual  value  and  the  annual 
charges.  In  the  case  of  short-term  leases  it  will  be  found 
most  convenient  to  charge  a  proportionate  part  against 
each  year's  revenue,  but  this  method  would  not  be  desir- 
able in  the  case  of  longer  leases,  as  it  is  not  sufficiently 
accurate.  The  annuity  method  would  be  more  desirable 
where  long  leases  are  concerned,  as  it  is  not  proper  that 
the  early  years  should  bear  the  carrying  charges  on  the 
full  purchase  price  in  addition  to  a  prorated  instalment  of 
the  principal. 

It  sometimes  happens  that  at  the  end  of  a  lease  there 
is  a  claim  for  damages  based  on  the  condition  of  the  prem- 
ises.    It  is  not  usually  possible  to  restrict  the  use  under 


422  AUDITING 

a  long  lease  to  ordinary  wear  and  tear.  The  amount 
thereof  will  vary  according  to  circumstances,  and  the  pos- 
sibility of  this  contingency  must  be  taken  into  considera- 
tion in  making  the  calculation.  When  there  is  an  agree- 
ment in  a  lease  calling  for  the  restoration  of  premises  to 
the  original  condition  at  the  termination  of  the  lease,  the 
estimated  expense  may  be  accumulated  and  spread  over 
the  years  of  the  life  of  the  lease. 

In  England,  where  leaseholds  are  far  more  common 
than  here,  the  annuity  system  is  usually  applied  and  the 
interest  on  the  investment  is  charged  each  year  on  the 
diminishing  value  of  the  lease.  The  amount  of  deprecia- 
tion is  fixed,  but  as  the  reserve  grows  larger  the  interest 
charges  decrease. 

When  new  buildings  are  erected  on  leased  land  the  full 
cost  thereof  will  have  to  be  provided  for  during  the  term 
unless  there  is  a  provision  for  revaluation  at  the  expiration. 
In  any  event  the  amount  which  will  disappear  from  the 
assets  at  the  end  of  the  lease  must  be  absorbed  equitably 
during  the  period.  The  annuity  system  is  suggested  as 
the  plan  most  suitable. 

Machinery  and  Equipment 

The  rate  of  depreciation  to  be  allowed  in  the  case  of 
machinery  has  been  the  subject  of  more  discussion  than 
any  other  allowance  of  this  nature.  So  many  factors 
enter  into  the  Hfe  of  machinery  that  it  is  absolutely  neces- 
sary for  each  machine  to  carry  its  own  individual  rate, 
and  this  can  be  determined  solely  by  experience.  In  the 
case  of  two  machines  exactly  alike  in  the  beginning  used 
in  different  factories,  there  may  be  a  considerable  differ- 
ence in  length  of  life  and  service;  consequently  no  hard- 
and-fast  rule  can  be  laid  down.  But  in  addition  to  charg- 
ing all  repairs  and  part  renewals  to  operating,  from  7^ 


DEPRECIATION  423 

to  121/2  P^r  cent  should  be  written  off  annually  from  the 
original  cost  to  provide  for  normal  depreciation  by  wear 
and  tear  and  obsolescence. 

Aside  from  the  question  of  obsolescence,  the  life  of  a 
heavy  machine  tool  is  usually  considered  as  15  to  20  years. 
On  the  other  hand,  the  rates  of  the  National  Machine 
Tool  Builders'  Association  should  have  weight.  These 
are  as  follow^s:  machinery,  10  per  cent;  frame  buildings,  5 
per  cent;  brick  buildings,  3  per  cent.  These  rates  are  for 
favorable  conditions  and  apply  to  the  total  original  value 
and  not  to  a  decreasing  value. 

It  is  invariably  desirable  that  a  subsidiary  ledger  should 
be  kept  containing  details  of  the  machinery  accounts  in 
the  general  ledger.  This  assists  in  arriving  at  rates  of 
depreciation  and  is  of  great  value  in  case  of  fire  or  in 
determining  the  amount  to  be  written  off  in  case  of  sale. 

A  considerable  part  of  the  ordinary  wear  and  tear  for 
which  depreciation  reserves  are  created  is  usually  charged 
to  operating  expenses  in  the  form  of  repairs  and  mainte- 
nance. Small  parts  of  machines  are  wearing  out  or  break- 
ing and  are  being  constantly  renewed.  In  some  cases 
nearly  ever>^  part  of  a  machine  may  be  renewable,  and  it 
is  quite  conceivable  that  at  the  end  of  five  or  six  years 
a  machine  may  be  largely  renewed  and  be  about  as  good 
as  new.  If  in  the  meantime  depreciation  at  the  rate  of 
10  per  cent  per  annum  has  been  reserved  without  any 
adjustment  for  new  parts  supplied  it  is  evident  that  the 
reserve  is  too  large. 

It  is  not  intended  to  advocate  any  reduction  in  or- 
dinary depreciation  rates,  but  it  is  suggested  that  the  care- 
ful auditor  should  study  the  relation  between  the  deprecia- 
tion reserve  and  the  physical  condition  of  the  machine. 
Reference  to  Professor  Cooley's  description  on  page  404 
herein  will  remind  us  that  machinery  to  serve  its  purpose 


424 


AUDITING 


properly  must  be  maintained  at  from  75  per  cent  to  85 
per  cent  of  its  original  condition,  therefore  there  is  no 
necessity  for  providing  the  cost  of  maintenance  plus  the 
wear  and  tear  element  of  depreciation  if  the  latter  is  fully 
covered  by  the  former. 

The  following  tables  compiled  by  George  A.  Cravens 
and  published  in  the  Electrical  Review,  April  23,  1910, 
are  of  interest.  Rates  of  depreciation  on  various  kinds 
of  equipment  as  estimated  in  connection  with  litigation 
and  by  recognized  authorities  are  shown. 

Table  II  indicates  the  variation  caused  by  light  or 
heavy  use. 


Table  I 

Items 

c 

cd  o 

■Hc3 
3  >, 

S6 

1 

c 
W 

V 

G 

1 

.2* 

K 

U 

g^ 

it 

^2 

> 
< 

> 

< 

C 
o 

in 

o 

% 

Boilers 

3.5-10 

6.6 

7.5 

6.6-8.5 

5 

8-10 

2.5-3.3 

4-6.6 

7.5 

Steam    Piping 

3.5 

6.6 

7.5 

5 

5 

8-10 

2.5-3.3 

5-8 

5 

Auxiliaries 

5-10 

6.6 

5 

6.6-8.5 

5 

8-10 

4-6.6 

3-5 

7.5 

Steam  Engines.. . . 

3-10 

6.6 

5 

5-6.6 

5 

5 

4-6 

2.5-5 

4-6.6 

5 

Steam  Turbines.  .. 

5 

5 

7-9 

2.5-5 

4 

4 

Belted  Generators. . 

5-10 

6.6 

7.5 

5 

5 

5-10 

6.6 

3.3-4 

7.5 

Wires  and  Cables. 

2 

6.6 

5 

2 

5 

3-5 

4-6.6 

5 

5 

Switchboard,  etc... 

2 

6.6 

5 

2 

7.5 

8-10 

2-5 

5 

Motors          ..... 

5-10 

6.6 
66 

5 
10 

5 

5 
5 

5-8 
9-11 

4-6.6 
5-10 

5 
6.6 

S 

Storage  Batteries.. 

10 

Shop   Equipment.  . 

3-10 

5 

7.5 

3.3-10 

7.5 

7.5 

12-15 

5 

4-10 

7.5 

Table  II 


Items  of  Equipment 


Boilers,  Water  Tube 

Boilers,  Fire  Tube 

Piping,  Steam  and  Water , 

Auxiliaries,  Steam 

Engines,  Steam , 

Turbines,  Steam 

Generators,    Belted , 

Wires  and  Cables 

Switchboards  and  Instruments, 

Motors  (A.  C.  and  D.  C.) 

Storage  Batteries 

Shop   Equipment,  Tools,  etc... 


Light  or 

Intermittent 

Service 


4-6.6 
5-6.6 

4-5.5 

3-5 

4-5 

3-4 

4-6.6 

3-5 

2-5 

4-6.6 

5-6.6 

5^10 


Heavy  or 

Continuous 

Service 


5-8.3 

6.6-10 

5.5-8.3 

4-6.6 

5-6.6 

4-5 

5-8.3 

4-6.6 

5-8.3 

5-8.3 

6.6-10 

7.5-15 


DEPRECIATION  425 


Small  Tools 


Small  tools  should  be  revalued  periodically,  thus  fix- 
ing accurately  the  rate  of  depreciation.  If  this  plan  is 
followed  for  several  years  and  a  dependable  rate  is  secured, 
it  may  be  feasible  to  omit  the  revaluation  for  a  year  or 
two,  applying  the  rate  previously  ascertained. 

Furniture  and  Fixtures 

Many  concerns  write  down  this  item  to  $1,  and  the 
practice  is  to  be  commended  unless  stockholders,  partners, 
or  other  interested  parties  are  being  deceived.  Where 
the  asset  is  a  large  one  such  a  course  is  not  so  feasible, 
but  there  is  no  doubt  that  this  item  is  usually  overvalued 
so  far  as  any  possibility  of  realization  is  concerned. 

Usually  in  a  going  business,  assets  are  not  treated  on 
the  basis  of  realization  values,  but  in  the  case  of  furniture 
and  fixtures  so  many  changes  are  made  to  suit  the  con- 
venience and  whims  of  executives  and  clerks,  and  ofifices 
are  moved  so  often  from  one  place  to  another,  that  furni- 
ture and  fixtures  have  a  most  uncertain  value. 

Office  partitions  are  frequently  built  at  the  expense  of 
tenants  and  are  worthless  at  the  end  of  the  lease.  In  the 
meantime  changes  are  often  made,  and  if  the  auditor  is 
careful  he  may  find  duplications  in  the  account. 

If  it  is  important  to  write  off  actual  depreciation  only, 
it  will  be  found  that  15  per  cent  per  annum  will  represent 
a  fair  average  allowance. 

Landlord's  Fixtures 

Leaving  out  of  consideration  the  complex  question 
as  to  what  are  and  what  are  not  landlord's  fixtures,  it  may 
be  laid  down  as  a  general  rule  that  the  minimum  rate  of 
depreciation  upon  machinery  and  fittings  erected  upon 
leasehold  property  should  be  written  off  at  a  rate  at  least 


426 


AUDITING 


sufficient  to  wipe  off  the  book  value  before  the  expiration 
of  the  lease. 

In  the  case  of  machinery,  etc.,  which  will  not  become 
landlord's  fixtures,  a  less  rate  may  be  permitted,  but  it  is 
imperative  that  in  such  a  case  it  should  be  clearly  under- 
stood and  agreed  what  are  to  be  the  landlord's  fixtures, 
and  what  are  not. 

Horses 

It  will  be  readily  seen  that  the  depreciation  of  horses 
and  other  animah  is  rapid  and  inevitable.  The  rate  of 
allowance  may  be  from  1.^  to  25  per  cent  of  the  cost.  By 
means  of  revaluation,  which  can  be  more  accurately  done 
in  the  case  of  horses  than  with  most  other  assets,  it 
should  soon  become  possible  to  determine  the  actual  rate 
of  depreciation.  These  revaluations  should  be  fairly 
frequent. 

Wagons,  Automobiles,  etc. 

In  the  case  of  wagons  it  will  be  found  that  8  to  10  per 
cent  per  annum  is  an  ample  allowance,  provided  that  all 
repairs,  renewals  of  parts  and  maintenance  are  charged 
to  operating  expenses. 

As  with  wagons,  most  of  the  parts  of  an  automobile 
can  be  replaced.  Under  ordinary  conditions  the  rate  of 
depreciation  on  automobiles  should  be  fixed  aL  from  15 
to  20  per  cent  per  annum.  The  most  expensive  parts, 
such  as  tires,  motors,  and  bodies,  may  be  easily  replaced, 
and  if  charged  to  operating  will  leave  unprovided  for  only 
accrued  depreciation  and  obsolescence. 

Ships 

Although  the  depreciation  of  ships  is  invariably  great 
and  must  be  the  subject  of  allowance,  it  is  a  difficult  mat- 


DEPRECIATION  427 

ter  to  lay  down  any  fixed  rate  to  be  written  off.  The 
amount  of  depreciation  should  be  certified  by  an  engineer, 
and  unless  there  appears  to  be  some  reason  to  doubt  the 
correctness  of  his  report,  the  auditor  is  not  responsible. 
The  auditor's  certificate  should  state  clearly  that  inade- 
quate allowance  for  depreciation  has  been  made  unless  an 
amount  has  been  provided  which  in  his  opinion  is  ample. 

Patents 

Although  it  is  true  that  some  value  may  attach  to  a 
patented  article  even  though  the  patent  has  run  out,  it 
is  generally  conceded  that  it  is  well  to  write  ofT  the  entire 
cost  of  a  patent '  during  the  period  of  protection.  The 
patent  derives  its  value  in  great  measure  from  the  fact 
that  it  is  a  monopoly,  and  the  moment  the  monopoly  has 
ceased  by  the  termination  of  patent  rights,  the  value  is 
seriously  affected,  if  not  entirely  wiped  out.  In  the  case 
of  a  patent  which  has  been  leased  and  not  purchased,  the 
item  should  not  be  treated  as  an  asset  except  to  the  extent 
of  its  actual  cost  in  fees,  etc.  To  capitalize  a  patent  lease 
at  any  sum  in  excess  thereof  would  be  as  incorrect  as  to 
capitalize  good-will,  although  both  are  latent  assets  in 
every  paying  concern. 

Copyrights  may  be  treated  in  a  similar  manner,  except 
that  their  commercial  value  generally  expires  long  before 
the  termination  of  the  copyright. 

The  original  life  of  a  patent  is  seventeen  years,  and 
renewals  are  dependent  upon  the  introduction  of  some 
essential  novelty. 

Good-Will 

While  good-will  does  not  depreciate,  it  is  constantly 
liable  to  fluctuations.  Good-will  is  not  usually  written 
off,  and  the  question  of  the  amount  at  which  it  shall 


428 


AUDITING 


stand  in  the  balance  sheet  was  not  formerly  deemed  to  be 
within  the  scope  of  the  auditor's  work,  but  the  present 
range  of  an  auditors  duties  compels  him  to  give  serious 
thought  to  this  item.  The  various  points  connected  with 
the  valuation  of  good-will  are  fully  discussed  on  pages  123- 
128  and  should  be  referred  to  in  case  a  question  arises  as 
to  writing  off  all  or  any  part  of  the  amount  at  which  good- 
will is  carried. 

WASTING  ASSETS 
Mines 

Depreciation  of  mines  is  equivalent  to  a  depletion  of 
mineral  wealth.  The  value  of  the  mine  to  the  owner  or 
lessee  has  decreased  at  the  end  of  a  year  by  exactly  the 
amount  of  ore  extracted.  But  on  account  of  the  uncer- 
tainty in  the  total  amount  of  ore,  its  quality  and  grade 
and  the  expense  which  may  be  involved  in  mining,  it  is  a 
difficult  matter  to  set  such  a  rate  of  depreciation  as  will 
represent  the  average  depletion  during  the  life  of  the  mine 
or  the  term  of  the  lease,  as  the  case  may  be.  The  only 
way  in  which  this  can  be  done  is  by  estimation,  which  is 
naturally  inaccurate  and  may  be  misleading. 

Under  most  state  laws  a  mining  company  is  not  com- 
pelled to  write  off  any  depreciation  before  declaring  a 
dividend,  but  it  is  generally  considered  better  finance  to 
write  off  annually  such  proportion  of  the  total  cost  less 
residual  value  of  plant  as  the  output  bears  to  the  estimated 
content  of  the  mine,  or,  in  case  of  a  leased  mine,  such  pro- 
portion of  the  total  cost  as  the  output  bears  to  the  output 
estimated  for  the  duration  of  the  lease. 

On  account  of  the  great  uncertainty  of  mining,  and 
the  fact  that  stockholders  object  to  the  accumulation  of 
large  reserve  funds,  which  would  earn  only  a  low  rate  of 
interest  and  might  just  as  well  be  distributed  as  dividends, 


DEPRECIATION 


429 


it  may  be  better  policy  that  mines  should  be  regarded 
as  non-permanent  undertakings  in  which  excesses  of  cur- 
rent revenue  might  be  distributed  without  regard  to  the 
value  of  the  remaining  assets  in  their  relation  to  the 
amount  of  paid-up  capital. 

Timber  Lands 

In  just  the  same  way  that  the  removal  of  a  ton  of  ore 
or  coal  reduces  by  so  much  the  value  of  the  mine,  so 
the  cutting  of  each  thousand  feet  of  timber  likewise  re- 
duces the  value  of  the  land  on  which  it  stood.  It  is  obvi- 
ous that  there  should  be  written  off  from  year  to  year 
such  proportion  of  the  cost  of  the  lands  as  the  quantity 
of  timber  cut  during  the  year  bears  to  the  quantity  stand- 
ing on  the  entire  tract  at  the  time  of  its  purchase. 

In  some  cases  allowance  for  the  value  of  the  cut-over 
lands  may  be  made  in  determining  the  amount  which 
should  be  charged  off  for  depletion  of  the  timber.  Very 
frequently,  however,  the  cut-over  land  has  but  little  value. 

Inasmuch  as  the  total  quantity  of  timber  standing  on 
a  tract  of  land  can  be  determined  with  m.uch  greater  cer- 
tainty than  is  the  case  with  the  contents  of  a  mine,  it 
follows  that  the  depletion  charge  per  thousand  feet  of 
timber  cut  can  be  more  accurately  fixed  than  is  true  of 
the  depletion  charges  for  mining  operations. 


CHAPTER    XIX 

INVESTIGATIONS 

Part  of  the  work  of  the  professional  auditor  is  desig- 
nated, not  as  an  audit,  but  as  an  investigation.  There  is 
here  an  actual  distinction,  just  as  the  work  of  the  account- 
ant may  be  differentiated  from  that  of  an  auditor. 

For  the  purposes  of  this  book,  audits  and  investiga- 
tions are  separated  only  as  to  the  special  points  to  be  ob- 
served in  the  latter,  it  being  assumed  that  in  many  investi- 
gations a  complete  detailed  audit  will  be  required,  and 
that  in  others  a  balance  sheet  audit  is  essential. 

Investigations  are  usually  undertaken  in  connection 
with  the  sale  of  a  business  to  a  corporation  or  other  pur- 
chaser for  the  purpose  of  obtaining  special  information 
relative  to  finances  or  general  affairs,  or  with  respect  to 
alleged  fraudulent  transactions,  or  into  the  profits  derived 
from  the  manufacture  of  infringing  articles,  etc. 

A  curious  feature  connected  with  investigations,  which 
rarely  arises  with  respect  to  audits,  is  the  attempt  on  the 
part  of  disreputable  promoters,  or  of  those  with  no  repu- 
tation at  all,  to  retain  the  services  of  reputable  auditors. 
Usually  the  enterprise  to  be  investigated  lacks  books  of 
account  and  promises  little  in  this  respect  for  the  future, 
or  a  company  has  been  formed  with  a  large  capital  stock 
on  one  side,  and  mining  claims  or  some  equally  uncertain 
asset  on  the  other.  A  certificate  is  desired  for  pubUcation, 
or  for  private  exhibition  to  prospective  investors. 

In  the  hands  of  an  honest  man,  an  auditor's  certificate 

430 


INVESTIGATIONS  43 1 

in  the  ordinary  form  might  be  unobjectionable,  but  if  the 
certificate  is  in  the  possession  of  an  unscrupulous  pro- 
moter, it  may  be  represented  to  be  an  unqualified  indorse- 
ment of  the  enterprise  and  its  promoters,  and  there  are 
enough  ignorant  investors  to  believe  these  or  stronger 
statements.  The  wise  auditor  will  never  permit  his  certifi- 
cate to  be  so  used,  for  a  single  mistake  of  this  kind  in 
sizing  up  a  client  may  mean  the  loss  of  one's  reputation. 
Successful  auditors  can  take  no  chances  at  all  in  this 
respect;  they  must  be  more  particular  about  their  clients 
than  a  bank  is  about  its  customers. 

The  various  classes  of  investigations  and  the  special 
features  of  each  class  will  be  discussed  in  the  following 
order: 

1.  Upon  the  sale  or  purchase  of  a  business. 

2.  To  ascertain  information  required  by: 

(a)  Creditors,   prospective  creditors,   or  stock- 

holders. 

(b)  Parties  to  litigation  or  disputes. 

3.  Investigation  of  suspected  fraud. 

SCOPE  OF  THE  WORK 

Instructions  from  Clients 

The  title  of  this  chapter  may  convey  the  impression 
that  the  work  to  be  done  is  more  or  less  restricted  in  its 
scope,  and  that  the  auditor  who  undertakes  an  investiga- 
tion for  a  special  purpose  may  expect  to  receive  special 
instructions,  differing  from  the  circumstances  under  which 
he  would  be  wilHng  to  make  an  audit.  It  is  not  claimed 
that  an  auditor  would  insist  on  proceeding  with  any  pro- 
fessional work,  including  audits,  which  appeared  to  be 
even  remotely  in  opposition  to  his  clients'  wishes.  He 
could  withdraw,  and  this  would  be  the  only  proper  course 


432 


AUDITING 


if  he  found  himself  unable  to  comply  with  the  directions 
of  those  for  whom  his  work  was  intended. 

As  a  member  of  a  profession  with  high  ideals,  he  can 
insist,  or  in  the  exercise  of  his  full  prerogatives  he  can 
demand,  that  instructions  outlining  the  scope  of  his  work, 
or  the  form  of  his  certificate  and  report,  shall  accord  with 
honorable  motives  and  straightforward  dealing.  Other- 
wise, he  cannot  proceed  without  forfeiture  of  his  self- 
respect. 

If  the  instructions  are  incomplete  and  the  auditor  fails 
to  interpret  them  broadly,  so  as  to  include  all  of  the  results 
which  are  called  for  by  the  nature  of  the  case,  he  should 
not  attempt  to  excuse  his  deficient  results  by  falling  back 
on  his  instructions.  Therefore,  at  the  commencement  of 
an  investigation  it  is  most  important  that  specific  instruc- 
tions be  issued  by  the  client,  or  prepared  by  the  auditor 
and  confirmed  by  the  client. 

Working  Papers  to  be  Preserved 

Following  up  his  instructions  from  the  client,  the 
auditor  will  issue  special  directions  to  his  own  staff.  The 
remarks  on  working  papers  (page  42)  apply  with  full 
force,  and,  in  addition,  special  care  must  be  taken  to  pre- 
serve all  data  bearing  on  the  adjustment  of  the  accounts. 
In  few  investigations  will  the  auditor's  report  show  ac- 
counts and  amounts  as  they  appear  on  the  books.  Even 
if  net  results  are  not  altered,  an  analysis  will  have 
been  made  resulting  in  a  different  arrangement  and 
presentation. 

It  is  of  the  utmost  importance  that  working  sheets  be 
prepared  and  retained  which  will  show  in  absolute  detail 
the  reconciliation  of  the  original  book  figures  with  those 
appearing  in  the  final  report.  Neglect  of  this  precaution 
may  subsequently  result  in  censure  for  neglect,  coupled 


INVESTIGATIONS 


433 


with  the  necessity  of  dupHcate  work,  for  which  a  charge 
cannot,  or  should  not,  be  made. 

In  some  cases  the  working  papers  of  an  audit  have  to 
be  referred  to  after  the  report  is  submitted,  but  in  nearly 
all  investigations,  questions  arise  after  the  work  is  com- 
pleted which  require  reference  to  the  data  compiled  during 
the  progress  of  the  work. 

Detail  Which  May  be  Omitted 

If  "investigation"  were  simply  another  name  for  an 
audit,  this  chapter  would  not  have  been  written. 

In  general  it  may  be  stated  that  as  an  investigation 
is  not  an  audit,  but  an  inquiry  into  specific  matters,  the 
routine  requirements  of  an  audit  as  outlined  in  this  book 
may  be  omitted.  Later  on,  the  features  which  must  not 
be  omitted  will  be  discussed. 

Previous  Audits 

It  has  also  been  mentioned  that  in  an  ordinary  engage- 
ment the  auditor  will  often  find  himself  to  be  the  first 
professional  auditor  who  has  been  consulted.  But  with 
investigations,  which  are  frequently  called  for  in  connec- 
tion with  consolidations  of  prosperous  enterprises,  it  will 
be  found  that  many  of  the  latter  have  had  their  accounts 
audited.  If  the  auditor  can  secure  the  reports  of  such 
examinations,  he  will  have  a  basis  upon  which  to  deter- 
mine what  use  he  can  make  thereof.  Obviously  this  basis 
will  depend  on  the  standing  of  the  other  auditors  and 
the  nature  of  their  reports. 

If  access  to  previous  reports  cannot  be  had,  the  auditor 
should  secure  permission  to  consult  with  the  previous 
auditors  for  the  purpose  of  securing  any  information  pos- 
sible. If  this  is  not  feasible,  he  will  have  to  proceed  as  if 
the  accounts  had  never  been  audited. 


434 


AUDITING 


Where  Assets  Are  Appraised 

It  is  becoming  fairly  general  in  an  investigation  to 
employ  appraisers  as  well  as  auditors.  The  former  must 
take  the  responsibility  for  physical  valuations  of  fixed 
assets  items,  and  while  this  is  of  great  assistance  to  the 
auditor,  he  should  never  incorporate  their  valuations  in 
his  accounts  without  considering  their  relation  to  the 
profit  and  loss  account.  The  auditor  should  steadfastly 
maintain  that  he  cannot  state  the  net  profits  of  a  business 
irrespective  of  an  examination  of  the  assets  and  Uabilities. 
If  the  book  assets  must  be  adjusted  to  an  appraisal,  the 
profit  and  loss  account  may  require  adjustment  also.  The 
word  "may"  is  used  advisedly,  as  some  appraisal  companies 
are  inclined  to  overvalue  physical  assets.  It  is  pleasing 
to  proprietors  (which  may  explain  why  it  is  done),  but 
it  does  not  always  afiFord  a  reasonable  basis  for  a  writing 
up  of  book  values  and  a  consequent  adjustment  of  the 
profits. 

On  the  other  hand,  in  view  of  this  tendency,  any  in- 
sufficiency of  assets  shown  by  an  appraisal  should  be 
reflected  in  the  profit  and  loss  account. 

Definite  Report  Wanted 

In  order  that  there  may  be  no  misunderstanding,  it 
should  be  understood  that  the  author  does  not  advocate 
submitting  suggestions  and  criticisms  based  on  mere 
hearsay,  or  on  incomplete  information.  The  point  to  be 
emphasized  is  that  all  facts  pertinent  to  the  inquiry  are 
permissible  and  may  be  of  more  value  than  a  mass  of 
figures. 

Certain  adjustments  are  necessary  in  practically  all 
investigations,  but  the  auditor  must  be  firm  in  arranging 
the  results  and  in  wording  his  report,  or  it  may  be  found 
that    the    final    conclusions    are    far    from    representing 


INVESTIGATIONS 


435 


a  well-thought-out  opinion  of  the   standing  of  the  busi- 
ness. 

Auditors  have  been  very  properly  warned  that  if  there 
is  nothing  definite  for  them  to  report,  they  should  not  be 
led  into  stating  that  if  the  expectations  of  the  promoter 
are  reaUzed  his  estimates  of  the  profits  are  correct. 

Handling  Books  and  Records 

Before  making  a  single  mark  of  any  description  in  a 
record  which  is  the  property  of  another,  the  auditor 
should  ask  himself  the  question:  "Is  there  any  possibility 
of  these  records  being  falsified,  and  might  it  embarrass 
me  later  if  it  were  shown  that  I  had  made  marks  herein?" 
In  every  case  the  question  should  act  as  a  reminder  that 
if  marks  are  warranted  they  should  be  small,  neat,  and  so 
made  as  to  be  readily  and  positively  identified  on  any 
subsequent  occasion. 

If  fraud  is  suspected,  it  is  always  desirable,  and  some- 
times necessary,  that  no  marks  at  all  should  be  made.  In 
such  a  case  the  entries  which  are  falsified  should  be 
rewritten  on  loose  sheets,  paged  the  same  as  the  original 
records,  and  the  correct  amounts  shown  in  an  adjoining 
column.  This  will  permit  a  summary  of  the  fictitious 
entries  being  made  up  at  ^any  time.  It  involves  an 
immense  amount  of  work,  however,  and  the  auditor 
should  advise  his  cHents  of  its  possible  cost. 

False  Entries  Sometimes  Forgeries 

The  entry  of  an  incorrect  amount  in  a  book  of  record, 
if  made  with  intent  to  defraud,  is  forgery,  and  therefore 
a  serious  crime. 

Frequently  false  entries  are  found  in  books  which 
indicate  that  the  one  responsible  therefor  has  misappro- 
priated an  equivalent  sum  of  money,  but  it  may  be  difficult 


436 


AUDITING 


to  produce  satisfactory  evidence  as  to  when  and  how  the 
defaulter  actually  took  the  cash. 

It  is  well  known  that  a  verdict  of  guilty  is  diflficult  to 
secure  from  a  jury  v  hen  the  evidence  consists  largely  of 
complicated  and  manipulated  accounts.  The  defaulter's  plea 
that  his  books  were  unfortunately  mixed  up,  but  that  he 
never  stole  anything,  appeals  to  the  sympathy  of  the  average 
man.  If  it  can  be  shown  conclusively,  however,  that 
certain  entries  are  fraudulent  on  their  face,  it  may  be 
possible  to  prove  a  charge  of  forgery.  An  auditor  should 
always  be  familiar  with  the  law  of  his  own  state  on  this 
subject. 

Books  as  Evidence 

Aside  from  the  question  of  fraud,  it  is  always  desirable 
that  books  and  records  be  kept  neatly  and  accurately, 
and  that  they  be  complete  and  co-ordinate.  In  other 
words,  there  can  be  no  possible  argument  against  accurate 
and  creditable  books  of  account,  but  serious  loss  may 
result  from  inaccurate  and  incomplete  records.  In  the 
course  of  time  a  considerable  number  of  business  enter- 
prises are  compelled  to  engage  in  litigation,  either  as 
plaintiffs  or  defendants,  in  which  the  books  of  account 
must  be  produced  and  offered  in  evidence,  and  many  cases 
are  lost  through  lack  of  evidence  on  some  vital  point  on 
account  of  insufficient  or  discreditable  data. 

The  auditor  will  have  many  opportunities  of  dealing 
with  the  wrong  kind  of  books,  which  experiences  will 
serve  as  examples  when  he  tells  his  clients  what  not  to  do. 

Loose-Leaf  Records 

It  was  formerly  held  that  loose-leaf  records  were  not 
proper  and  sui^cient  evidence,  by  reason  of  the  supposed 
danger  of  substitution,   but   business   custom  and   con- 


INVESTIGATIONS  437 

venience  forced  a  change,  so  that  today  these  records, 
when  bearing  on  their  face  all  the  signs  of  regularity,  are 
admitted  without  question. 

The  chief  point  to  bear  in  mind  in  any  event  is  the 
effect  on  a  jury.  Carelessly  kept  bound  books  may  have 
an  adverse  effect,  while  neatly  kept  loose-leaf  records,  in 
binders,  may  impress  the  jury  as  containing  complete  and 
dependable  records  of  the  transactions  in  question. 

Erasures 

The  matter  of  erasures  is  one  to  which  the  auditor 
should  give  some  attention.  It  directly  affects  the  neat- 
looking  pages  which  some  bookkeepers  love,  but  it  may 
be  laid  down  as  a  general  rule  that  an  incorrect  figure 
ruled  out,  and  with  the  correct  amount  inserted  above, 
always  stands  for  itself,  while  an  erasure  or  alteration  is 
sometimes  hard  to  understand.  If  it  should  develop  at 
some  later  day  that  the  altered  figure  is  one  required  to 
base  an  action  or  defense  upon,  the  position  of  the  clerk 
responsible  therefor  is  not  an  enviable  one. 

The  one  great  factor  is  accuracy,  and  to  this  beauty 
must,  if  there  is  need,  be  subordinated. 

Original  Records  Necessary 

The  foregoing  remarks  lead  up  to  a  consideration  of 
the  value  of  records  which  are  merely  transcripts  of  others, 
or  to  which  the  entries  in  other  books  have  been  posted. 

In  England  it  is  customary  to  keep  certain  original 
records  in  more  or  less  "rough"  form,  and  subsequently 
transfer  the  entries  to  "fair"  books.  In  such  a  case  the 
moment  it  is  shown  that  a  certain  book  is  merely  a  copy  of 
another,  and  was  written  subsequently,  it  loses  most  of 
its  value  and  the  original  record  is  called  for.  If 
destroyed,  the  entire  case  might  be  lost. 


438 


AUDITING 


This  possibility  contains  a  twofold  lesson:  It  em- 
phasizes the  desirability  of  making  all  original  records  part 
of  the  double-entry  system  of  accounts  without  rewriting, 
and  in  addition  insures  the  preservation  of  records  which 
may  be  called  for  when  least  expected. 

The  Auditor  as  an  Expert  Witness 

Few  professional  auditors  escape  their  day  in  court  as 
expert  witnesses.  The  necessity  usually  arises  out  of 
investigations  where  fraud  or  disputes  are  known  to  exist, 
but  experience  teaches  that  fraud  may  be  discovered  in 
any  audit,  and  in  cases  where  it  is  least  expected.  There- 
fore, the  auditor  must  look  upon  himself  at  all  times  as  a 
potential  witness.  Neglect  to  give  proper  weight  to  this 
possibility  has  caused  considerable  embarrassment  on 
more  than  one  occasion  where  an  auditor  has  placed 
someone  in  charge  of  an  audit  who  is  not  qualified  to  make 
a  creditable  witness.  Sometimes  assistants,  thoroughly 
equipped  in  other  respects,  are  constitutionally  unfitted  to 
appear  as  expert  witnesses. 

Part  of  the  program  of  an  audit,  consequently,  is  a 
provision  for  the  substitution  of  an  experienced  senior  or 
principal  as  soon  as  the  work  has  gone  far  enough  to 
warrant  the  assumption  that  an  appearance  as  a  witness  is 
probable. 

The  author  has  testified  as  an  expert  witness  scores 
of  times,  and  submits  the  following  suggestions  based 
entirely  on  practical  experience: 

I.  Preparation  Is  Always  Essential 

The  average  lawyer  does  not  prepare  his  cases 
properly,  because  the  majority  are  settled  without  suit, 
or  when  called  are  so  frequently  continued  from  time  to 
time  that  he  finds  it  fairly  safe  to  take  a  chance  of  waiting 


INVESTIGATIONS  439 

until  the  trial  or  reference  is  on  before  going  into  the 
details  of  the  accounts  upon  which  he  purposes  to  examine 
the  accountant. 

This  makes  it  all  the  more  necessary  for  the  accountant 
to  be  ready.  Unfortunately,  the  lawyer's  excuses  are 
received  with  less  annoyance  than  the  accountant's,  and 
the  latter  must  be  ready  to  go  into  any  or  all  phases  of 
the  matter  on  a  moment's  notice,  or  the  lawyer,  and 
through  him  the  client,  becomes  impatient. 

The  section  on  working  papers  (page  38)  should  be  read 
at  this  point.  Failure  to  make  full  and  proper  memoranda 
during  the  examination  is  as  annoying  subsequently  as  the 
failure  to  find  data  required,  either  because  it  is  not 
properly  arranged  or  filed,  or  because  the  query  raised 
was  not  foreseen. 

2.  A  Witness  Can  Testify  to  His  Own  Work  Only 

While  an  expert  witness  is  permitted  to  present 
synopses  and  summaries  prepared  from  records  offered  in 
evidence,  and  is  thus  not  compelled  to  produce  his  re- 
sults item  by  item,  yet  he  must  testify  that  the  results 
to  which  he  testifies  are  his  own  preparation  and  not 
the  work  of  others.  The  state  of  mind  of  the  presiding 
judge  usually  decides  this  point  where  there  is  any 
dispute. 

The  author  has  found  it  valuable  to  have  ready  for 
inspection  certain  of  the  working  papers  written  in  his 
own  handwriting.  The  attorney  for  the  other  side  almost 
invariably  raises  this  point  when  he  thinks  there  is  any 
likelihood  of  any  of  the  work  having  been  performed  by 
others,  and  where  the  witness  has  a  large  practice,  and  is 
thought  to  be  dependent  largely  on  the  work  of  assistants, 
or  where  the  report  indicates  that  one  man  could  not 
possibly  have  compiled  all  of  the  data  within  a  limited 


440  AUDITING 

period  of  time.  It  is  of  the  utmost  importance,  therefore, 
that  the  witness  should  be  ready  to  state  that  the  results 
to  which  he  is  testifying  are  his  own  work;  that  he  brought 
the  figures  together;  that  if  he  did  not  perform  all  of  the 
detail  work,  it  was  done  under  his  supervision,  and  that 
he  presents  it  as  his  work. 

3.  Information  Should  Not  Be  Volunteered 

As  an  accountant  is  supposed  to  testify  to  facts  only,  he 
will  make  the  best  impression  when  he  answers  questions 
explicitly  and  stops  when  he  thinks  the  question  has  been 
answered. 

If  the  attorney  is  not  fully  conversant  with  the  details 
of  the  case,  the  accountant  should,  before  the  hearing  or 
trial  commences,  prepare  for  the  attorney  written  ques- 
tions designed  to  bring  out  all  of  the  matter  favorable  to 
his  client's  side  of  the  case. 

The  auditor  should  never  be  asked  to  suppress  facts 
within  his  knowledge,  and  cannot  honestly  do  so,  no 
matter  how  much  pressure  is  brought  to  bear,  but  no  code 
of  ethics  recommends,  or  as  a  matter  of  fact  permits,  a 
professional  man  to  volunteer  to  outsiders,  or  to  the 
opposing  side  in  litigation,  facts  which  would  injure  his 
client. 

The  accountant  having,  as  a  part  of  his  duty,  provided 
the  means  whereby  favorable  facts  will  be  disclosed,  must 
in  every  legitimate  way  guard  against  the  disclosure  of 
unfavorable  facts.  As  intimated  above,  he  must  answer 
any  pertinent  question,  no  matter  how  much  the  answer 
may  hurt  his  client,  but  if  there  is  any  possibility  of  such 
a  question,  in  cross-examination,  being  irrelevant,  or 
improper,  he  should  give  his  own  attorney  plenty  of  time 
to  object  before  replying,  and  if  he  is  instructed  to  answer, 
his  duty  lies  solely  in  telling  the  truth,  and  there  should 


INVESTIGATIONS 


441 


be  no  volunteering  of  information  for  which  the  question 
does  not  specifically  call. 

4.  Conclusions  and  Opinions 

Practitioners  differ  as  to  how  far  an  accountant  is 
justified  in  testifying  as  to  his  opinions  where  the  facts  at 
hand  may  not  be  conclusive  enough  for  him  to  state  posi- 
tively that  his  testimony  is  founded  on  conclusions  based 
solely  on  facts  and  figures  contained  in  the  records  offered 
in  evidence. 

Frequently  the  records  are  incomplete,  but  enough 
data  may  have  been  compiled  to  warrant  a  definite  opinion 
as  to  certain  results.  Where  the  witness  is  acting  in  good 
faith,  and  is  interested  only  in  seeing  that,  as  far  as  he  is 
concerned,  substantial  justice  is  being  done,  it  may  be 
urged  that  his  duty  to  his  client  requires  the  presentation 
of  all  the  evidence  possible,  and  that  the  other  side  can 
be  depended  upon  to  object  to  anything  going  in  unless 
the  ground  work  of  relevancy  has  been  laid. 

On  the  other  hand,  it  is  contended  that  an  accountant, 
as  a  witness,  should  be  absolutely  impartial  and  dis- 
interested, that  he  should  state  the  bare  truth  and  be 
oblivious  of  which  side  it  might  affect.  The  author  has 
heard  this  argument  for  many  years,  but  in  the  course  of 
his  experience,  which  has  brought  him  into  contact,  on 
one  side  or  the  other,  with  the  leading  accountants  in  this 
country,  he  has  invariably  found  that  the  accountants  are 
more  or  less  interested  in  their  side  and  the  presentation 
of  the  facts  favorable  to  their  side,  and  he  has  failed  to 
detect  any  signs  of  pure  disinterestedness  on  the  part  of 
any  one  of  them. 

Furthermore,  he  has  found  in  many  instances  that  the 
accountants  have  been  better  advocates  for  their  clients 
than  the  attorneys  themselves,  this  being  demonstrated 


442  AUDITING 

not  only  by  their  testimony  under  oath,  but  by  their  skill 
in  suggesting  questions  to  the  attorneys,  and  these  ques- 
tions have  been  directed  to  all  witnesses,  and  not  to  tliose 
only  who  are  examined  on  the  accounts. 

To  sum  up:  the  present  practice  seems  to  be  for 
accountants  to  promote  in  all  legitimate  ways  the  success 
of  the  side  of  Htigation  on  which  they  are  retained,  and 
they  are  not  found  to  be  unconcerned  and  oblivious  of 
results;  that  the  attorneys  and  parties  to  the  cases  know 
that  this  is  the  practice;  that  they  are  relying  more  and 
more  on  professional  auditors  to  assist  in  the  preparation 
of  matters  in  litigation;  and  that  the  attorneys  and  others 
who  have  a  first-hand  knowledge  of  the  present  practice 
do  not  see  any  impropriety  in  it. 

The  author  has  no  criticism  to  make  of  this  procedure, 
but  on  the  contrary  believes  that  the  accountants  who 
have  in  many  cases  signally  helped  their  clients  by  extra 
zeal  would  have  fallen  short  of  their  full  duty  if  they  had 
maintained  the  attitude  of  a  machine  which  shows  final 
results,  but  which  cannot  make  suggestions  as  to  how 
those  results  may  be  used. 

1.   ON  SALE  OR  PURCHASE  OF  A  BUSINESS 

The  professional  auditor  is  now  being  consulted 
frequently  by  the  man  who  wishes  to  sell  as  well  as  the 
man  who  wishes  to  buy.  The  former  realizes  that  the 
services  of  an  independent  auditor  are  of  the  utmost  value 
to  him  in  stating  the  ramifications  of  his  business  so 
clearly  that  he  will  not  omit  any  favorable  aspects  in 
dealing  with  a  prospective  purchaser.  Likewise,  the 
buyer  feels  that  he  cannot  afTord  to  depend  on  the  repre- 
sentations of  the  seller  nor  on  his  own  judgment.  One 
may  pay  too  high  a  price  and  the  other  may  sell  at  too  low 


INVESTIGATIONS  443 

a  price  unless  the  professional  auditor  passes  upon  the 
proposition. 

It  is  generally  recognized  by  leading  accountants  that 
when  an  auditor  represents  a  prospective  purchaser,  much 
that  is  necessary  in  an  ordinary  audit  may  be  omitted.  It 
is  safe  and  legitimate  to  assume  that  the  seller  will  not 
underestimate  his  profits,  nor  his  assets,  and  that  he  will 
not  overstate  his  liabilities. 

Briefly  stated,  if  the  auditor  finds  actual  net  earnings 
and  assets  equaling  the  representations,  and  no  more 
liabilities  than  are  claimed,  he  need  not  spend  unnecessary 
time  on  an  inspection  of  the  expense  vouchers  and  similar 
work. 

The  chief  points  of  difference  which  may  arise  between 
an  investigation  of  this  kind  and  an  audit,  are  the 
following: 

(a)  Something  more  than  figures  are  wanted. 

(b)  Period  covered. 

(c)  Analysis  of  earnings  and  expenses. 

(d)  Future  requirements  and  economies. 

(e)  System  of  accounts. 

(f)  Elimination  of  unusual  items. 

(g)  Adjustments  and  qualifications, 
(h)   Errors  in  the  books. 

(i)  Investigation  on  behalf  of  a  retiring  partner  when 
the  business  is  being  sold  to  a  continuing 
partner. 

(j)  Investigation  for  those  in  charge  of  reorganiza- 
tions. 

(a)   Requirements 
Something  More  Than  Figures  Wanted 

The  prospective  purchaser  of  a  business  wants  to  know 
as  much  of  its  past  history  as  a  man  does  of  his  prospective 


444  AUDITING 

bride.  He  usually  contemplates  joining  fortunes  for  an 
indefinite  period,  and  his  associations  must  represent  more 
than  mere  financial  gain.  Who  is  better  equipped  to  pass 
on  the  enterprise  from  almost  every  point  of  view  than 
an  experienced  auditor? 

Most  accountants  feel  that  their  full  duty  has  been 
discharged  when  they  submit  a  balance  sheet  and  a  profit 
and  loss  statement,  together  with  such  comments 
thereon  as  modify  the  figures  submitted.  Outside  of 
these  figures  they  will  not  go,  on  the  theory  that  to  do  so 
would  mean  a  departure  from  facts  into  the  realm  of 
theory. 

Nothing  could  be  more  inconsistent!  The  figures 
shown  are,  with  very  few  exceptions,  estimates  only.  The 
stock-in-trade  is  always  worth  something  more  or  less 
than  the  inventory  valuation.  The  fixed  assets  vary  in 
value  to  such  an  extent  that  book  valuations  are  usually 
shown  because  actual  values  are  unknown.  The  accounts 
receivable  are  valued  on  past  experience,  which  may  be 
deceptive.  There  may  be  contingent  liabilities  of  large 
amount  unknown  and  not  provided  for.  Therefore, 
certain  conclusions  as  to  the  conduct  of  the  business,  the 
trend  of  prices,  and  other  general  information  may  be 
compiled  by  the  auditor  and  reported  upon  with  about  as 
much  dependability  as  the  accounts. 

What  does  a  prospective  purchaser  want?  It  is  not 
enough  that  the  report  of  the  auditor,  the  appraiser,  or 
the  engineer  show  that  the  assets,  as  represented,  are  in 
existence  or  that  the  earnings  equal  the  guaranteed  esti- 
mates. It  is  of  quite  as  much  importance  to  be  assured 
that  the  management  as  it  existed  at  the  time  of  the 
examination  was  all  that  could  be  desired.  Assets  are 
sometimes  accumulated  and  earnings  realized  through 
cumulative  circumstances  which  are  no  longer  a  factor, 


INVESTIGATIONS 


445 


or  under  the  administration  of  men  no  longer  connected 
with  the  enterprise. 

In  the  United  States,  new  industries  or  special  and 
ingenious  processes  may  have  been  responsible  for  large 
profits  which  subsequently  become  reduced  through  the 
natural  economic  law  of  competition  and  imitation.  Capi- 
tal flows  to  unusually  profitable  enterprises  as  surely  as 
water  finds  its  level. 

Suppose  the  business  under  investigation  has  shown 
unusual  profits  up  to  the  date  of  the  last  balance  sheet. 
Is  the  auditor  charged  with  the  duty  of  forecasting  a 
probable  change?  Perhaps  not,  but  many  enterprises  have 
failed  to  maintain  past  profits,  although  the  latter  have 
been  actual,  and  the  auditor's  certificates  thereto  true  in 
all  respects.  In  some  cases  bankruptcy  has  resulted 
within  a  year  after  the  flotation  of  a  stock  or  bond  issue, 
due  entirely  to  a  drop  in  gross  profits  caused  by  competi- 
tion, the  removal  of  tariff  protection,  compulsory 
reduction  in  rates  by  public  authority  or  private  demand, 
or  reckless  or  fraudulent  practices. 

The  auditor  is  not  and  would  not  be  held  responsible 
for  losses  arising  out  of  these  contingencies,  but  if  the 
downward  movement  were  starting  during  the  course  of 
his  examination,  should  he  not  convey  his  impressions  to 
his  client?  It  may  be  said  that  a  prospective  purchaser 
should  think  of  these  things  himself.  Perhaps  he  should, 
but  he  doesn't. 

The  author  has  followed  this  line  of  suggestion  more 
or  less  for  some  years,  and  has  found  that  the  comments 
are  well  received  and  always  appreciated,  even  though  his 
advice  may  not  always  be  followed. 

An  auditor  who  expects  to  perform  a  considerable 
amount  of  investigating  in  the  course  of  his  practice  will 
find  it  very  useful  to  compile  statistics  of  various  busi- 


446 


AUDITING 


nesses.  This  may  seem  to  be  a  formidable  undertaking, 
but  it  may  not  be.  It  so  happens  that  the  proprietors  of 
a  business  will  hear  that  a  certain  auditor  has  just 
completed  an  examination  of  the  books  of  some  one  in 
the  same  line  as  themselves.  They  feel  that  he  has 
acquired  special  knowledge  relative  to  methods,  etc., 
which  may  be  beneficial  to  them.  It  should  be  remarked 
in  passing  that  only  in  the  rarest  cases  has  an  auditor  been 
asked  to  reveal  any  confidential  information  which  he  has 
secured  from  a  competitor. 

But  the  auditor  may  for  his  own  information  compile 
statistics  as  to  what  a  certain  kind  of  business  should  earn, 
and  what  its  expenses  and  costs  should  be.  Without 
revealing  the  source  of  his  information,  he  may  be  able 
to  ofifer  constructive  suggestions  or  in  the  case  of  a 
purchase  or  sale,  or  other  investigation,  he  may  be  able 
to  comment  more  intelligently  on  the  accounts  than  if 
he  were  dependent  entirely  on  the  data  compiled  in  each 
particular  case. 

There  is  another  line  of  investigation  which  is  not 
often  reflected  in  a  report:  Are  the  accounts  to  which  the 
auditor  will  certify,  prepared  directly  from  the  current 
books  of  account,  or  are  they  the  result  of  special  compila- 
tion? If  the  latter,  is  the  actual  state  of  the  books  an 
indication  of  neglect  or  ignorance?  Have  the  proprietors 
kept  themselves  informed  as  to  the  results  of  operations 
through  monthly  or  other  frequent  periodical  statements, 
or  have  they  waited  for  definite  results  until  the  end  of 
their  fiscal  year,  when  an  inventory  is  taken? 

Have  they,  therefore,  been  dependent  entirely  upon 
intuitive  knowledge,  which  is  possessed  more  or  less 
(chiefly  less)  by  executives  who  scorn  theory  and  accounts, 
and  who  boast  of  the  value  of  practical  experience?  Are 
the  departments  co-ordinated,  or  do  they  run  independ- 


INVESTIGATIONS  447 

ently  to  such  an  extent  that  one  does  not  know  what  the 
other  is  doing?  Is  it  a  fact  that  certain  departments  are 
a  law  unto  themselves,  that  they  run  along  and  write  up 
copious  records  which  are  never  used  by  those  to  whom 
they  might  be  supposed  to  be  of  value? 

All  of  these  queries  and  many  more  might  be  answered 
offhand  by  an  auditor  who  had  completed  an  investigation 
into  assets,  liabilities,  and  earnings,  but  he  could  not 
properly  report  thereon  unless  he  had  been  in  contact 
with  every  department  of  the  business.  Having  this  infor- 
mation, why  should  he  not  report  thereon  verbally  or  in 
writing? 

All  these  suggestions  have  a  bearing  on  the  two 
thoughts  which  are  uppermost  in  the  mind  of  a  prospec- 
tive purchaser,  viz.,  ''Taking  everything  into  considera- 
tion, is  the  business  a  desirable  acquisition?"  and  "How 
much  is  it  worth?"  The  auditor  may  not  wish  to  give  a 
definite  answer  to  either  question,  but  he  can  furnish 
figures  and  other  information  which  will  be  of  the  utmost 
interest. 

(b)  Period  Covered 

As  stated  at  the  commencement  of  this  chapter,  the 
auditor  should  require  definite  instructions  before  starting 
an  investigation.  These  instructions  usually  specify  the 
period  to  be  covered.  As  a  prospective  purchaser  wishes 
to  know  absolutely  all  that  is  possible  about  the  past,  it 
is  usual  to  verify  the  earnings  for  as  many  years  back-  as 
time  will  permit.  Three  years  would  be  a  minimum,  while 
ten  years  would  not  be  too  long  a  period  for  those  who 
expect  to  make  a  permanent  investment. 

As  will  be  pointed  out  later,  it  is  not  necessary  to  audit 
the  accounts  in  the  usual  sense.  An  analysis  is  all  that  is 
required.     Therefore,  it  is  very  little  more  work  to  cover 


448  AUDITING 

six  years  than  three,  unless,  of  course,  the  records  for  past 
years  are  incomplete  or  inaccurate.  The  longer  the 
period,  the  more  accurately  will  the  trend  of  the  busi- 
ness be  shown.  Most  enterprises  have  good  and  poor 
years,  and  the  respective  recurrence  of  these  is  of  great' 
interest. 

In  no  event  should  the  results  of  two  or  more  years  be 
lumped.  A  big  year  and  a  small  year  might  make  a  satis- 
factory average,  but  few  wish  to  invest  in  a  business  where 
the  small  year  is  the  last.  Therefore,  each  year  must  be 
shown  separately,  and  averages  never  used  unless  the 
actual  results  of  the  last  year  or  two  are  substantially 
above  the  average. 

The  auditor  must  not  fail  to  inspect  the  results 
between  the  date  of  the  balance  sheet  and  the  time  of  the 
examination.  The  most  recent  month  should  be  com- 
pared with  the  same  month  for  previous  years,  and  if  an 
unfavorable  result  is  shown,  the  fact  should  be  reported. 

(c)  Analysis  of  Earnings  and  Expenses 

Gross   Earnings 

In  an  audit  it  is  always  important  to  verify  the  gross 
earnings.  In  many  investigations  the  prospective  pur- 
chaser is  greatly  interested  therein  and  is  almost 
indififerent  with  respect  to  the  net.  He  says  that  with  his 
own  appraisement  of  the  physical  property,  and  a  personal 
knowledge  of  local  conditions,  he  requires  nothing 
additional  except  an  accurate  statement  of  the  gross 
receipts  or  earnings  of  the  enterprise  in  order  to  determine 
upon  the  price  he  is  willing  to  pay  for  the  property.  The 
reason  is  that  an  experienced  executive  knows,  or  thinks 
he  knows,  the  proper  ratio  of  operating  expenses  which 
will  be  incurred  under  proper  management,  and  it  is  of 


INVESTIGATIONS  ^g 

little  moment  to  him  how  much  the  old  management  has 
expended. 

This  procedure  is  followed  in  connection  with  the  sale 
of  public  utility  companies  oftener  than  with  any  other 
class.  The  sales  or  output  of  these  companies  is,  of  course, 
more  nearly  constant  and  dependable  than  with  trading  or 
manufacturing  enterprises.  But  capable  men  in  nearly  all 
lines  are  found  willing  to  invest  in  a  business  with  which 
they  are  familiar,  and  if  reasonably  assured  of  a  minimum 
of  gross  earnings,  will  undertake  to  guarantee  a  maximum 
of  operating  cost,  irrespective  of  what  the  previous  owner 
may  have  done. 

Recently  a  large  and  unsuccessful  taxicab  company 
was  purchased  by  a  competitor  who  was  willing  to  guar- 
antee a  satisfactory  profit  on  the  purchase  price  if  operated 
separately  and  an  additional  saving  if  consolidated  with 
his  own  company.  He  had  managed  a  business  with 
exactly  the  same  problems  as  those  of  his  competitor,  and 
had  been  able  to  produce  a  large  profit  out  of  smaller  gross 
earnings.  He  knew  the  competitor's  shortcomings 
without  seeing  an  analysis  of  its  expenses.  (Subsequently, 
however,  he  found  that  the  problems  were  not  all  the 
same,  and  the  expected  results  did  not  materialize.) 

This  illustrates  the  importance  of  a  thorough  under- 
standing of  the  client's  viewpoint  before  commencing  an 
investigation.  If  a  purchaser  is  chiefly  interested  in  gross 
earnings,  the  auditor  will  take  great  care  to  state  them 
properly,  looking  carefully  into  the  sources  of  revenue, 
comparing  one  period  with  another,  and  noting  any 
deductions  therefrom  in  the  shape  of  discounts,  returns, 
allowances,  etc.  The  latter  should  be  deducted  from  the 
gross  earnings  and  not  included  among  the  expenses.  He 
will  then  state  the  expenses  and  costs  as  shown  by  the 
books  and  make  such  verification  only  as  may  be  required. 


450  AUDITING 

Net  Earnings 

On  the  other  hand,  if  a  prospective  purchaser  does  not 
have  any  preconceived  ideas  as  to  the  proper  relation 
between  gross  and  net  earnings,  the  auditor  will  make  his 
examination  exhaustive  enough  to  enable  him  to  prepare- 
and  submit  full  and  complete  analyses  of  expenses  as  well 
as  earnings. 

The  comparative  statements  of  earnings  will  afford 
profitable  data  relating  to  the  progress  of  the  enterprise. 
Of  all  businesses  in  which  a  purchaser  is  interested,  the  one 
with  a  stable  earning  power  and  small  but  sure  earnings 
is  preferred  to  the  one  which  fluctuates  violently.  Many 
business  men  manufacturing  a  novelty,  or  working  under 
patents,  have  an  unusually  prosperous  year  due  to  lack  of 
competition  or  some  similar  cause.  They  immediately 
talk  of  incorporating  or  reincorporating  on  the  basis  of 
the  one  year's  earnings,  and  commence  to  spend  money 
as  if  it  were  an  annuity  instead  of  the  returns  from  an 
exceptional  year. 

The  auditor  who  is  consulted  in  such  a  case  will  do 
his  client  a  kindness  if  he  will  point  out  the  wisdom  of 
waiting  until  he  can  show  a  good  three  or  five-year 
average  before  he  is  justified  in  considering  his  business 
as  on  a  stable  basis,  and  one  in  which  others  will  care  to 
invest. 

Fluctuations  must  be  noted  and  explained.  Gross 
earnings  depend  largely  on  general  business  conditions, 
but  costs  and  expenses  do  not,  as  a  rule,  vary  to  the 
same  extent. 

It  is  necessary  to  obtain  an  analysis  of  the  accounts 
and  be  able  to  report  the  various  stages  from  gross 
earnings  to  net  profits.  In  a  trading  business,  for 
instance,  the  following  form  of  statement  brings  out  the 
information  which  a  prospective  purchaser  requires: 


INVESTIGATIONS 


451 


A  B  COMPANY 

CompMlUve  Statement  of  EARNINGS  AND  EXPENSES  for  3  years  ended 

May  31,  1913 

Ykabb  Endxo 


GsomSau^: 

Less  AUowanoM  and  ReturoB    .    . 

Bs: 

res   . 
UEz. 

1013 
May  31 

Per 

Cent 

1912 
May  31 

Per 
Ctot 

1911 
May  31 

Ftt 
Cent 

= 

~ 

NetSales    ...... 



Inyentory.  beginning  of  period  .    .    . 
Puroha8es.net     ........ 

Lees  Inventory  end  of  peiiod    .    . 

CostofSales 

Gross  Profit 

Ratio  to  Sales 

Ratio  to  Cost 

Bbllwo  Expekses: 

Salesmen's  Salaries 

Salesmen's  EspenSBs       .     .    .     . 

Commissions 

Advertising          ..... 

Catalogs 

Delivery  Expenses 

::'::*: 

:::::::: 

::''*:: 

Total  Selling  Expeoseft     .    . 

:::::: 

RaUo  to  Sales 

(UnHKISTRATIOK  AND  GlNEBiL  EXPINBI 

Executive  Salaries 

Office  Salaries 

Stationery  and  Office'Supplies  .     '. 
Telephone  and  Telegraph    .     .     . 

Postage 

Traveling  Expenses        ,     .     .     . 

Legal  Expenses 

Rent 

Insurance        

Light,  Heat,  and  Power 

Buiidmg  Repairs,  and  Muntenance 
Depreciation  on  Furniture  and  Fixtu 
Miscellaneous           

:::::::: 

::::::: 

:::::: 

Total  Admmistration  and  Gener 
penses     .     .     .         . 



Ratio  to  Sales    .     #    .-  . 
Total  Expenses      ,     .     .     . 

i 

Net  Earnings     .     ,    .     . 
ttmrocnoNs:  Interest  on  Loans,  ete. 



•NetPtpfit 



It  will  be  noted  that  the  percentages  shown  are  gross 
profit  to  sales,  gross  profit  to  cost,  selling  expenses  to 
sales,  administration  and  other  expenses  to  sales.  As  an 
investigation  implies  a  comparison  of  two  or  more  years. 


452  AUDITING 

these  percentages  are  of  more  value,  relatively,  than  the 
amounts.  The  net  profit  for  each  year  being  shown,  the 
next  most  important  thing  is  to  know  how  it  was  made. 
If  the  sales  were  about  the  same  for  two  successive  years, 
the  variation  in  the  percentages  of  expenses  would  be 
most  interesting,  and  to  a  prospective  purchaser  it 
might  be  a  deciding  factor  to  learn  that  while  the  selling 
expenses  increased,  the  administration  expenses  decreased. 

Verification  of  Sales 

It  will  be  assumed  that  all  sales  except  of  recent  date 
will  be  verified  otherwise  than  through  the  sales  records. 
That  is,  after  being  charged  to  the  personal  accounts  of 
customers,  if  overdue  they  will  be  handled  as  doubtful 
accounts. 

As  it  is  customary  to  accept  recent  sales  as  collectable, 
it  is  necessary  for  the  auditor  to  satisfy  himself  that  they 
are  bona  fide  and  not  manipulated  to  produce  a  good 
showing  just  before  the  date  of  the  balance  sheet. 

The  more  common  forms  of  manipulation  are: 

1.  Inclusion  of  goods  sent  on  consignment  and 
approval  as  completed  sales.  This  practice  may  result 
from  ignorance,  rather  than  fraudulent  intent. 

2.  Sales  or  earnings  may  have  been  unduly  inflated  by 
charging  out  wholly  fictitious  quantities  and  amounts. 
Where  the  earnings  arise  from  cash  sales,  the  amount  by 
which  the  earnings  are  to  be  increased  is  arbitrarily  added 
to  the  daily  receipts.  At  least  one  instance  is  known  of 
the  improper  increase  of  street  railway  fares  by  a  promoter 
who  planned  ahead  to  sell  out.  He  knew  that  the  purchase 
price  would  be  calculated  on  a  certain  number  of  times  the 
net  profit  realized,  or  be  based  on  the  gross  earnings  of  the 
most  recent  period. 

It  will  be  seen  that  if  the  good-will  of  a  property  were 


INVESTIGATIONS  453 

to  be  sold  on  a  basis  of  four  times  the  average  net  earnings 
for  the  last  two  years,  any  method  of  increasing  such 
earnings  would  at  least  double  the  cost  thereof,  i.e.,  the 
addition  to  cash  sales  of  each  $100  would  be  divided  by 
two  to  get  the  average  for  two  years  and  then  multi- 
plied by  four  to  arrive  at  the  purchase  price,  thus  yield- 
ing a  profit  of  at  least  100  per  cent  for  the  fraudulent 
practice. 

A  scheme  of  this  nature  must  necessarily  be  planned 
ahead,  which  does  not  apply  to  most  manipulations.  This 
makes  it  extremely  difficult  to  detect,  and  no  general 
test  can  be  devised  which  will  surely  uncover  the  fraud. 
The  auditor  who  keeps  constantly  before  him  the  pos- 
sibility of  fraud  designed  to  inflate  the  earnings  will  have 
the  best  chance  of  discovering  it. 

Where  the  legitimate  cash  sales  or  receipts  are  small, 
no  one  would  be  bold  enough  to  inflate  them  to  any 
considerable  extent.  Therefore,  the  most  feasible  method 
is  to  enter  among  the  bona  fide  sales  fictitious  names, 
quantities,  and  amounts.  This  fraud  will  be  disclosed  to 
the  auditor  who  investigates  the  average  number  of  new 
customers'  accounts  opened  within  a  given  period.  Any 
unusual  increase  would  be  worth  while  looking  into  in  any 
event.  If  legitimate,  the  question  of  a  continuation 
thereof  would  be  important;  if  not  legitimate,  it  would 
be  even  more  important  to  uncover  the  irregularity. 

If  there  has  been  an  increase  in  prices  shortly  before 
the  date  of  the  balance  sheet,  the  cause  thereof  should  be 
investigated.  Such  increases  are  not  always  maintained, 
and  it  would  be  unsafe  to  depend  thereon  unless  the  most 
positive  evidence  could  be  secured  of  the  propriety  and 
wisdom  of  the  change. 

It  may  also  have  been  the  case  that  special  contracts 
have  been  undertaken  which  have  realized  large  profits, 


454  AUDITING 

but  which  may  never  be  repeated.  For  instance,  a  small 
steam  railway  company  reaped  the  advantage  of  a  military 
encampment  during  a  considerable  part  of  one  summer. 
The  increase  over  its  normal  traffic  was  enormous.  Yet  a 
prospective  purchaser  would  have  no  assurance  whatever 
of  a  repetition  of  such  earnings. 

The  period  after  the  closing  date  up  to  the  time  of  the 
investigation  must  be  scanned  closely  for  rebates,  allow- 
ances, and  returns  to  see  if  they  constitute  deductions 
from  prior  sales.  Likewise,  the  subsequent  sales  will  be 
inspected,  particularly  if  suspiciously  small,  as  it  might 
indicate  that  shipments  after  the  closing  date  were  carried 
back  and  charged  under  false  dates. 

It  will  not  be  sufficient  to  be  informed  that  the  out- 
standings have  been  guaranteed  by  the  vendors,  making  a 
valuation  unnecessary.  It  might  be  that  fictitious  sales 
have  been  entered  in  order  to  make  a  good  showing,  the 
vendors  calculating  that  they  can  well  afford  to  stand  the 
apparent  losses  arising  out  of  the  non-collection  of  such 
items.  The  auditor  should  keep  this  possibility  in  mind, 
and  where  the  vendors  or  guarantors  make  good  any 
considerable  amount  in  this  respect,  the  details  of  the 
accounts  should  be  inquired  into. 

The   Turnover 

-  Authorities  difYer  greatly  as  to  what  this  term  means. 
The  dictionary  definitions  are:  "A  completed  commercial 
transaction";  *'The  money  receipts  of  a  business  for  a 
given  period." 

The  merchant  who  speaks  of  his  ''turnover"  usually 
refers  to  his  gross  sales,  but  if  his  answer  were  analyzed 
it  would  be  found  that  his  reference  was  rather  to  his 
stock  of  goods  than  to  the  sales  value  thereof.  If  he 
started  his  fiscal  year  with  a  certain  inventory,  he  would 


INVESTIGATIONS 


455 


endeavor  to  "turn  it  over"  several  times  during  the  year. 
In  this  case  it  would  mean  the  cost  of  the  sales,  because 
his  inventory  and  subsequent  purchases  are  entered  at 
cost,  and  it  is  this  stock  that  he  is  endeavoring  to  turn 
over  to  the  greatest  possible  advantage. 

The  banker  does  not  look  with  favor  on  the  borrower 
whose  gross  sales  are  not  several  times  as  much  as  his 
starting  inventory,  and  it  is  a  fair  inference  that  sales  and 
cost  of  sales  are  here  used  interchangeably. 

Uniformity  is  desirable  in  accountancy  terminology,  so 
the  author  suggests  this  definition:  The  turnover  of  a 
merchant  or  manufacturer  represents  the  number  of  times 
his  capital  in  the  form  of  stock  in  trade  is  reinvested  in 
stock-in-trade  during  a  given  period. 

To  ascertain  the  turnover,  take  the  starting  inventory, 
add  the  purchases  or  cost  of  manufactured  goods,  and 
deduct  the  inventory  at  the  end;  divide  the  total  by  the 
starting  inventory.  The  calculations  are  based  upon  a 
normal  inventory.  The  result  will  be  the  number  of  times 
the  capital  invested  in  stock-in-trade  has  been  turned  over 
during  the  period. 

The  capital  invested  in  the  stock  and  the  physical 
stock  itself  may  be  used  synonymously  in  referring  to  the 
"turnover"  of  a  business. 

Profits  on  Fluctuations 

Many  enterprises  using  staple  raw  materials  frequently 
buy  their  requirements  in  advance,  and  in  numerous 
instances  have  found  it  more  profitable  to  sell  their  entire 
stock  on  a  rapidly  advancing  market  than  to  operate  their 
mills.  This  occurs  oftener  with  cotton  than  with  any 
other  commodity,  but  the  practice  obtains  in  other  lines, 
such  as  grain,  pork,  copper,  etc. 

If  such  profits  are  actually  realized,  they  should  appear 


456 


AUDITING 


as  a  special  item  in  the  current  profit  and  loss  account. 
On  the  other  hand,  if  the  transactions  have  resulted  in  a 
net  loss,  the  most  conservative  method  will  be  to  include 
the  loss  in  the  current  accounts,  on  the  theory  that  an 
extraordinary  profit  should  not  be  counted  as  operating 
income,  but  that  safety  will  not  permit  a  loss  to  be 
ignored,  inasmuch  as  it  will  have  to  be  paid  out  of  current 
earnings. 

Decrease  in  Expenses 

The  expenses  of  all  classes  will  be  compared  for  a 
number  of  years.  If  there  has  been  any  considerable 
decrease  during  the  period  shortly  before  the  balance 
sheet  date,  a  careful  analysis  should  be  made  to  determine 
the  possibility  of  the  omission  of  liabilities  which  have 
been  incurred,  but  the  entry  and  payment  thereof 
postponed. 

The  auditor  must  look  at  all  expense  payments  after 
the  closing  of  the  books;  if  unduly  large,  the  vouchers 
should  be  examined  and  their  dates  noted,  as  some  of 
them  may  be  for  expenses  incurred  prior  to  the  close  of 
the  fiscal  period. 

Advertising  and  Other  Deferred  Charges 

It  will  be  found  that  excessive  valuations  are  fre- 
quently placed  upon  the  prospective  earning  power  of 
advertising  and  other  forms  of  exploitation.  In  the 
publishing  business,  for  instance,  it  has  been  considered 
permissible  to  capitalize  the  expenses  of  establishing  a 
magazine.  There  is  no  possibility  nor  expectation  of 
recouping  the  preliminary  expenses  out  of  the  earnings 
of  the  first  year  or  two.  If  succcessful,  the  early  advertising, 
etc.,  will  have  been  justified  and  should  bQ  charged  against 
the  years  w^hich  reap  the  bcnefitj 


INVESTIGATIONS 


457 


In  practice,  however,  the  result  is  not  ideal.  Many 
periodicals  have  incurred  large  preliminary  expenses, 
capitalized  same,  and  have  never  been  able  to  charge  off 
any  part  thereof  against  earnings.  Other  publications 
which  have  shown  a  loss  in  their  early  years  because  no 
deferred  charges  were  carried  over  have  realized  large 
enough  profits  in  subsequent  years  to  recoup  all  the  pre- 
liminary expenses. 

It  is  a  difficult  matter  to  settle  at  best,  but  is  doubly 
hard  for  a  prospective  purchaser.  The  best  advice  to  give 
is  to  suggest  that  if  the  business  has  been  running  for 
some  time,  all  such  charges,  unless  very  recent,  should 
have  been  absorbed,  and  that  if  too  recent  to  forecast  the 
result,  the  purchase  of  the  prospective  profits  arising 
therefrom  is  a  pure  gamble,  modified  perhaps  by  evidence, 
if  available,  of  what  similar  advertising  expenditure  has 
produced  in  the  past.  An  English  prospectus  contained 
the  certificate  of  a  chartered  accountant  as  to  profits 
realized  over  a  period  of  years  ''before  charging  interest, 
management  salaries,  and  advertising." 

Leases 

If  the  concern  under  investigation  does  not  own  the 
land  and  buildings  within  which  its  business  is  transacted, 
the  matter  of  the  lease  and  renewals  thereof  is  of  the 
utmost  importance.  It  is  safe  to  estimate  that  out  of 
one  hundred  leases  for  a  long  term,  or  which  provide  for 
extensions,  more  than  Y5  per  cent  call  for  a  higher  rental 
during  the  later  years  than  at  the  beginning  of  the  term. 
Where  the  renewal  rate  is  not  fixed,  it  usually  is  to  be 
based  on  an  appraisal,  and,  in  perhaps  every  case,  it  is 
contemplated  by  owner  and  lessee  that  the  future  rental 
to  be  fixed  on  such  appraisal  will  be  higher  as  a  result 
thereof. 


458 


AUDITING 


Therefore,  the  prospective  purchaser  must  ascertain 
definitely  whether  he  can  retain  the  same  premises  for  a 
reasonable  time  if  he  so  decides,  and  whether  the  prospects 
for  an  increased  business  or  other  equivalents  will  compen- 
sate for  the  increased  expense  if  a  long  lease  is  desired. 
Conversely  a  prospective  purchaser  may  not  be  willing 
to  buy  the  business  unless  it  can  be  removed  economically 
to  a  new  location.  In  such  a  case  a  long  lease  might  in 
itself  prevent  the  consummation  of  the  deal. 

Strange  as  it  may  seem,  prospective  purchasers  do  not 
always  think  of  these  matters  during  the  early  stages  of 
negotiations.  The  auditor  should  ascertain  the  precise 
state  of  afifairs  with  respect  to  the  lease  before  he 
enters  upon  an  investigation  of  earnings,  the  result  of 
which  has  no  interest  for  a  purchaser  w^ho  may  not  have 
known  that  a  long  lease  on  an  ascending  scale  could  not 
be  disposed  of. 

In  other  cases,  a  purchaser  may  be  negotiating  for 
sevefal  properties  with  the  intention  of  consolidating 
them.  It  may  be  part  of  his  plans  to  unite  them  all  in 
one  place.  Obviously  the  terms  of  the  leases,  if  any,  are 
of  extreme  importance. 

Sometimes  mergers  are  effected,  and  plants  consoli- 
dated, leaving  certain  plants  idle.  If  the  plans  of  the 
promoters  contemplate  leasing  the  idle  plants  at  a  remu- 
nerative rate,  or  leave  out  of  consideration  the 
continuation  of  the  payment  of  rentals  which  cannot  be 
evaded,  a  serious  difference  between  estimated  and  actual 
profits  might  ensue. 

In  conclusion,  it  cannot  be  stated  too  strongly  that 
the  location  of  a  business  may  determine  its  success  or 
failure,  and  any  facts  or  opinions  relative  thereto  which 
the  auditor  can  furnish  will  be  of  the  greatest  interest  to 
his  client. 


iNVESTIGAtiONS 


45$ 


inventories 

In  an  investigation  for  a  prospective  purchaser  the 
question  of  inventories  is  one  of  the  most  important. 
Little  need  be  added  to  the  discussion  on  this  subject 
on  pages  88-98  except  that  the  distinction  must  be 
especially  noted  between  valuations  properly  incident  to 
a  going  business  and  those  which  apply  in  case  of  a 
purchase. 

Naturally  and  properly  the  purchaser  wishes  to  buy  as 
cheaply  as  possible,  and  the  seller  desires  to  realize  as  high 
a  price  as  he  can  secure.  But  in  representing  one  or  the 
other,  the  auditor  cannot  allow  any  such  considerations 
to  afifect  his  mind  in  arriving  at  the  earnings.  The  latter 
should  be  the  same,  whether  prepared  for  a  vendor  or  a 
vendee. 

Inventories  vitally  afifect  the  profit  and  loss  account 
and  the  good-will  of  a  business  rests  upon  the  profits 
reaHzed.  The  result  is  that  inventories  actually  fix  or 
materially  control  the  purchase  price  of  the  business, 
because  the  overstatement  of  an  inventory  results  in  an 
overstatement  of  profits. 

An  auditor  need  not,  and,  as  a  matter  of  fact  he 
cannot,  be  entirely  indifferent  to  the  interests  of  his  client. 
If  he  represents  a  purchaser,  it  is  almost  certain  that  the 
seller  will  have  stated  the  inventories  at  the  highest  pos- 
sible price,  so  that  he  need  not  be  particularly  concerned 
about  not  doing  justice  to  him. 

Obviously,  a  purchaser  does  not  wish  to  acquire 
"souvenirs"  illustrative  of  former  unsuccessful  sales  cam- 
paigns, no  matter  how  willing  the  vendor  may  be  to  part 
with  them.  With  this  thought  in  mind  the  auditor  should 
be  able  to  analyze  the  inventory  for  the  purpose  of 
disclosing  unsalable  goods. 

The   experienced   auditor  will   prepare  a   report    the 


460 


AUDITING 


accuracy  of  which  he  can  maintain  before  conflicting 
interests  if  misunderstandings  arise,  as  is  often  the  case 
when  commercial  enterprises  change  hands. 

Other  Factors  Which  Affect  Earnings 

Inasmuch  as  all  of  the  items  of  assets  and  liabilities,  as 
well  as  all  sources  of  income  and  every  class  of  expenses, 
enter  into  the  final  adjustment  of  the  profit  and  loss 
account,  the  auditor  should  not  pass  finally  upon  the 
amount  of  net  profit  or  net  loss,  to  which  he  will  certify, 
unless  he  has  covered,  or  intentionally  left  untouched,  all 
of  the  procedure  required  in  a  balance  sheet  audit.  The 
practitioner  who  does  not  have  his  own  program  for  an 
investigation  is,  therefore,  referred  to  the  chapters  of  this 
book  describing  a  balance  sheet  audit. 

(d)  Future   Requirements  and   Economies 

An  Auditor  Should  Not  Prophesy 

The  author  has  taken  the  position  that  an  auditor  is 
bound  to  furnish  his  client  all  of  the  information  bearing 
on  the  investigation  or  audit  which  he  believes  to  be 
reliable  and  relevant,  and  that  he  is  by  no  means  limited 
to  the  figures  which  any  intelligent  bookkeeper  might 
compile. 

But  it  must  be  understood  most  positively  that  it  is 
never  permissible  for  an  auditor,  as  such,  to  certify  to 
future  earnings  or  future  results.  An  auditor  can  express 
his  opinion  as  to  the  effect  particular  transactions  will 
have  if  applied  to  a  future  date.  For  instance,  an  auditor 
would  be  justified  in  stating  that  if  a  million  dollars  of 
bonds  were  sold  at  par  the  bank  account  would  be 
increased  by  the  same  amount.  But  an  auditor  would 
not  be  justified  in  stating  over  his  signature  that  if  a 


INVESTIGATIONS  461 

million  dollars  of  bonds  were  sold  at  par  and  invested 
in  the  business,  savings  would  result  sufficient  to  net  an 
additional  profit.  This  would.be  pure  surmise,  for  unex- 
pected losses  or  expenses  might  more  than  offset  the 
savings,  or  the  additional  capital  might  be  lost  entirely 
through  errors  of  judgment  in  its  expenditure. 

Business  men  and  financiers  frequently  ask  their  audit- 
ors to  calculate  the  effect  certain  changes  will  have  on 
the  results  of  operations.  For  instance,  an  auditor  will 
be  asked  to  prepare  a  statement  showing  the  probable 
outcome  if  gross  sales  are  doubled,  with  no  proportionate 
increase  in  fixed  charges.  This  is  proper,  profitable,  and 
pleasing  work  for  a  public  accountant,  and  he  should 
welcome  the  engagement,  but  it  must  be  distinctly  under- 
stood, before  the  work  commences  and  after  it  is  finished, 
that  his  work  is  performed  in  the  capacity  of  an  accoun- 
tant and  not  that  of  an  auditor.  He  should  refrain  from 
submitting  his  estimates  on  paper  which  bears  his  name 
at  the  top  or  the  bottom,  otherwise  there  is  a  risk  of  the 
figures  being  put  forth  as  if  they  were  certified  to. 

Great  pressure  is  sometimes  brought  to  bear  on  audit- 
ors to  have  them'  certify  to  what  are  in  reality  only  esti- 
mates. It  is  an  astonishing  fact  that  certificates  have 
been  issued  which  are  so  worded  that  the  untrained  mind 
reads  therein  that  the  auditor  is  satisfied  that  if  certain 
additional  capital  is  raised,  or  something  of  that  kind, 
there  will  be  sufficient  earnings  to  pay  a  large  return 
thereon.  The  auditor  who  lends  his  name  to  such  near- 
fraud  should  be  expelled  from  any  accounting  body  to 
which  he  may  belong. 

There  are  a  number  of  matters  which  afYect  the  future 
upon  which  an  auditor  may  and  should  give  his  opinion, 
and  he  may  and  should  discuss  the  relation  which  such 
matters  have  to  the  past,  but  in  no  case  should  these  be 


462  AUDITING 

grouped  in  such  a  way  that  there  can  be  read  into  the 
opinion  a  conclusion  as  to  the  future  net  profit  or  net  loss 
of  an  enterprise.  The  author  believes  that  this  is  the  best 
test  to  apply  when  in  doubt  as  to  how  far  an  auditor 
should  go  in  furnishing  information. 

InsufHcient  Capital 

For  instance,  a  business  may  have  had  insufBcient 
working  capital,  and  discounts  may  not  have  been  taken 
advantage  of.  A  prospective  purchaser  may  ask  that  a 
report  be  compiled  which  will  assume  adequate  cash 
capital.  An  analysis  of  past  purchases  may  definitely  fix 
the  saving  which  would  have  been  made,  but  the  point 
at  issue  is  whether  or  not  a  like  saving  can  be  realized 
in  the  future. 

If  an  auditor  is  asked  to  prepare  a  statement  setting 
forth  the  past  results  and  then  stating  that  in  his  opinion 
the  following  period  will  produce  a  given  result,  assuming 
the  saving  of  discounts,  he  is  going  far  beyond  his  prov- 
ince. But  if  in  his  opinion  the  discounts  will  continue, 
or  some  equivalent  thereof,  there  can  be  no  valid  objection 
to  his  stating  in  a  certificate  that  assuming  ample  capital 
and  upon  the  same  volume  of  business  there  will  be  one 
item  of  saving,  mentioning  the  amount. 

There  may  be  other  undue  expenses  or  losses  due  to 
insufficient  capital,  but  most  of  the  arguments  advanced 
as  to  what  would  have  been  accomplished  are  fallacies. 

Naturally  a  prospective  purchaser  wants  to  know 
wherein  economies  can  be  effected  or  profits  increased, 
and  evidence  may  be  available  to  prove  the  truth  of  the 
representations  made.  The  most  common  claim  is  that 
the  output  has  been  too  small,  and  that  additional  facili- 
ties would  have  meant  greatly  increased  profits.  Output, 
however,  must  be  sold  to  produce  a  profit,  and  it  is  always 


INVESTIGATIONS 


4O3 


easier  to  talk  about  a  big  increase  in  sales  than  to  secure 
actual  orders.  Men  who  are  partially  successful  frequently 
overestimate  the  buying  capacity  for  what  they  sell.  The 
market  may  readily  consume  all  that  is  offered,  but  if  the 
offerings  were  to  double,  the  sales  price  of  the  whole 
might  be  reduced  to  an  unprofitable  basis. 

Large  capital  is  by  no  means  a  guarantee  of  financial 
success,  and  any  investigation  into  the  capital  required 
for  a  particular  business,  the  effect  of  a  lack  of  it  in  the 
past,  and  the  possible  returns  therefrom  in  the  future, 
calls  for  more  acumen  and  general  business  knowledge 
than  most  men  possess.  Nevertheless,  there  are  times 
when  an  auditor  can  be  of  substantial  value  in  such  an 
investigation,  and  there  can  be  no  objection  to  his  plac- 
ing at  the  disposal  of  his  cHent  the  benefit  of  his  experi- 
ence, but  for  his  own  sake  he  must  not  permit  the  pub- 
lication of  a  certificate  which  can  be  directly  or  indirectly 
interpreted  as  a  statement  of  future  results. 

Comments  on  future  requirements  should  always  be 
accompanied  by  a  statement  as  to  the  average  net  capital 
employed  in  the  old  business.  This  will  afford  an  oppor- 
tunity for  a  prospective  purchaser  to  arrange  for  addi- 
tional capital  if  the  old  is  inadequate. 

Economies  Exaggerated 

One  has  but  to  read  some  of  the  glowing  prospectuses 
issued  a  few  years  ago  to  appreciate  the  difference  between 
expectation  and  realization.  Fortunately  not  much  of  the 
responsibility  for  the  failure  of  many  large  enterprisv-^s  can 
be  traced  to  auditors,  but  a  part  of  the  blame  might  not 
be  improperly  placed  on  their  shoulders. 

It  has  been  stated  in  these  pages  that  an  accountant 
should  be  available  to  make  calculations  and  compile  data, 
for  which  others  would  take  the  responsibility.     This  is 


464 


AUDITING 


true,  but  no  public  accountant  should  ever  work  in  the 
capacity  of  a  clerk.  He  may  assist  in  the  preparation  of 
a  statement  which  purports  to  show  the  economies  to  be 
effected  by  a  merger  of  two  or  more  concerns,  but  if, 
through  ignorance  or  lack  of  experience,  estimates  are 
made  which  the  accountant  knows  cannot  be  fulfilled,  he 
should  not  hesitate  to  express  his  convictions,  and  if  it 
appears  that  facts  are  to  be  ignored  and  the  public  de- 
ceived, he  had  better  withdraw  in  order  to  avoid  any 
possible  connection  with  the  enterprise. 

Almost  without  exception  promoters  have,  or  seem 
to  have,  visions  of  two  or  more  plants  being  conducted 
on  about  the  same  expense  ratio  as  the  most  economical 
of  those  merged.  Economies  in  all  departments  are- 
prophesied,  and,  as  a  matter  of  fact,  many  are  possible  and 
are  effected.  But  they  are  sorely  needed  to  offset  the 
extraordinary  expenses  and  extravagances  which  seem  to 
be  a  necessary  element  in  the  promotion  and  establish- 
ment of  all  such  consolidations. 

To  start  with,  vast  sums  are  paid  in  cash  or  securities 
to  promoters,  attorneys,  and  insiders.  Then  engineers 
and  accountants  must  receive  large  fees,  although  far  less 
in  proportion  than  those  paid  the  lawyers. 

The  bankers,  lawyers,  and  others  who  become  mem- 
bers of  the  board  would  not  think  of  attending  a  board 
meeting  at  the  dingy  business  offices  of  one  of  the  old  con- 
cerns, so  a  large  and  expensive  suite  of  offices  is  secured 
"downtown."  With  expensive  offices  go  expensive  clerks, 
and  so  on  down  the  line.  How  many  poorly  paid  clerks 
and  others  must  be  dismissed  at  the  works  to  pay  a  frac- 
tional part  of  the  new  and  additional  expenses  which  were 
not  referred  to  in  the  prospectus? 

If  anyone  thinks  this  description  is  an  exaggeration, 
let  him  examine  a  few  of  the  popular  consolidations. 


INVESnCATIONS  465 

Former  Owners'  Attitude 

Except  in  rare  cases  the  business  which  changes  hands 
or  consoHdates  with  others  has  been  prosperous.  It  is 
conceded  that  the  personal  element  is  the  most  important 
factor  in  business  life,  so  that  if  the  personal  attention  of 
the  former  proprietor  is  not  available  after  the  sale  takes 
place,  it  is  absolutely  essential  that  an  equivalent  be 
found,  or  the  success  of  former  years  will  not  be  dupHcated. 

This  is  another  of  the  matters  with  which  an  auditor 
is  not  usually  concerned,  but  no  one  has  a  better  oppor- 
tunity to  observe  the  relative  position  of  each  person 
responsible  for  the  former  prosperity  than  the  auditor 
who  investigates  the  finances  of  the  business  for  a  series 
of  years.  If  the  examination  makes  it  apparent  that  one 
or  more  of  the  proprietors,  rnanagers,  or  other  officials 
were  dominant  in  its  afifairs,  there  can  be  no  reasonable 
objection  to  this  fact  being  communicated  to  the  pros- 
pective purchaser. 

Many  men  think  that  ordinary  ability,  coupled  with 
plenty  of  money,  can  win  success  in  almost  any  Hne  of 
business,  but  this  is  not  true,  as  may  be  proved  beyond 
•a  doubt  by  examining  for  a  while  the  bankruptcy  an- 
nouncements. Many  concerns  which  start  in  business 
with  ample  capital  fail  because  they  are  not  properly  man- 
aged. Other  concerns  with  less  capital,  doing  precisely 
the  same  kind  of  business,  during  the  same  period  of 
time,  will  realize  large  profits. 

One  of  the  most  striking  instances  is  that  of  the  whole- 
sale grocery  business.  Here  conditions  are  nearly  equal. 
The  same  kinds  of  goods  are  bought  and  sold.  The  same 
customers  are  available  to  all,  yet  in  the  same  city  one 
concern  will  earn  large  profits,  while  another  doing  a  large 
business  will  not  earn  a  dollar  of  net  profit.  It  is  due 
to  the  personnel  of  the  management,  and  where  success- 


^^^  AUDITING 

ful  executives  can  be  retained,  an  auditor  will  not  be 
exceeding  his  duty  if  he  comments  on  the  matter. 

Competition 

Some  business  men  wish  to  expand,  or  consolidate,  or 
do  something  else  that  sounds  big  just  as  soon  as  they 
have  had  one  big  year.  It  usually  happens  that  the 
extraordinary  profits  earned  have  been  due  to  a  monopoly 
of  a  certain  kind  of  product.  Now  economic  laws  will 
adjust  an  inordinate  profit  by  stimulating  competi- 
tion. Publicity  which  follows  a  sale  or  the  publication  of 
earnings  will,  of  course,  spread  the  knowledge  of  large 
profits. 

An  exception  may  be  noted  in  the  case  of  patented 
articles,  where  the  continuance  of  a  monopoly  is  pro- 
tected by  law.  But  where  there  are  no  patents  of  vital 
importance,  the  question  of  competition  must  be  seriously 
considered. 

Another  element  which  affects  competition  is  the  per- 
sonal attention  referred  to  in  the  preceding  section.  If 
the  business  deals  in  any  goods  which  are  dependent  upon 
the  taste  of  the  public,  it  must  be  borne  in  mind  that  the- 
public  is  very  fickle. 

Popular  demand  may  be  increased  by  advertising  or 
maintained  more  or  less  by  fair  dealing  and  courteous 
treatment,  but  no  one  can  foretell  what  the  future  will 
develop  in  the  way  of  competition,  and  for  this  reason  a 
prospective  purchaser  must  think  deeply  before  he  com- 
mits himself  to  a  proposition,  which,  to  yield  a  satisfactory 
return  upon  the  purchase  price,  will  have  to  continue  to 
earn  so'  large  a  gross  profit  that  there  is  an  endeavor  to 
keep  the  facts  secret. 

How  long  an  economic  law  can  be  arrested  is  for  the 
purchaser  to  decide. 


INVESTIGATIONS  467 

(e)  System  of  Accounts 

Criticisms  Should  be  Postponed 

In  special  investigations  such  as  here  discussed,  the 
auditor  should  never  express  an  opinion  as  to  the  condi- 
tion of  the  accounts,  except  in  a  confidential  report  to 
the  prospective  purchaser.  During  the  course  of  the  work 
he  must  accept  things  as  he  finds  them,  and  in  order 
to  secure  the  sympathy  or  co-operation  of  the  ofifice  stafY, 
he  must  be  careful  to  praise  anything  which  deserves 
praise,  and  refrain  as  much  as  possible  from  criticizing 
accounts  or  methods  which  cannot  be  approved. 

When  the  purchase  is  consummated  and  the  auditor 
is  requested  to  submit  suggestions  and  criticisms,  then 
his  working  papers  should  disclose  full  information  avail- 
able for  use. 

Condition  of  Accounts  an  Index  to  Proprietors 

There  are  some  particularly  shrewd  bankers  who  make 
frequent  purchases  of  properties,  and  in  other  cases  fur- 
nish capital,  who  consider  that  an  auditor's  report  on  the 
condition  of  the  accounts  reflects  very  accurately  the  kind 
of  men  who  have  been  running  the  business. 

If  profits  have  been  large  and  no  accounts  worthy  of 
the  name  have  been  kept,  it  is  apparent  that  these  men 
have  depended  upon  their  own  ability  to  earn  money,  and 
as  this  cannot  be  sold  and  transferred  very  readily  it  is  not 
a  safe  plan  to  continue  such  incomplete  records. 

Preparation  for  New   System 

Therefore,  in  their  contracts  the  bankers  sometimes 
insert  stipulations  along  the  following  lines: 

1.  That  within  sixty  days  after  the  formation  of  the 
new  company,  public  accountants  satisfactory  to  the  pur- 
chasers shall  be  employed  to  devise  and  install  a  modern 


468  AUDITING 

system  of  accounts  for  the  company  which  will  permit  of 
full  and  accurate  reports  of  its  operations  and  its  financial 
condition  being  made  at  least  monthly.  (In  many  cases 
this  provision  is  objected  to,  but  bankers  are  anxious  to 
have  the  accounts  reorganized  wherever  dependable  re- 
sults are  not  readily  available,  and  therefore  hesitate  to 
finance  a  company  whose  accounts  are  unsatisfactory.) 

2.  That  said  accountants  shall  be  furnished  all  requi- 
site information  and  facilities  for  carrying  into  effect  such 
changes  as  may  be  necessary,  and  that  the  ofificers  and 
employees  of  said  new  company  shall  co-operate  wath  the 
accountants  in  the  installation  and  completion  of  the  new 
system  within  a  reasonable  time,  which  in  no  event  shall 
exceed  twelve  months  from  the  date  hereof. 

3.  That  the  reports  contemplated  by  said  proposed 
new  system  shall  be  delivered  each  month  to  the  board  of 
directors  of  the  new  company,  one  copy  thereof  to  remain 
on  file  with  the  secretary  of  the  company,  subject  to  the 
inspection  of  any  member  of  the  board,  and  one  copy 
thereof  to  be  mailed  each  month  to  the  purchasers,  as  long 
as  the  (preferred)  stock  is  not  retired. 

4.  That  in  the  event  of  accountants  being  employed 
for  the  purposes  heretofore  stated,  then  the  said  account- 
ants shall  be  retained  to  audit  the  accounts  of  the  new 
company  at  least  annually.  If  the  system  in  use  is  satis- 
factory and  accountants  are  not  required  immediately, 
they  shall  in  any  event  be  retained  to  audit  the  accounts 
at  least  annually;  copies  of  their  report  to  be  delivered 
and  filed  as  set  forth  in  paragraph  3. 

5.  If  vendors  do  not  name  accountants  satisfactory 
to  purchasers,  the  latter  may  nominate  and  the  vendors 
agree  to  employ  accountants  so  nominated  and  to  carry  out 
the  provisions  referring  to  accountants  with  the  same  effect 
as  if  said  accountants  were  appointed  by  the  vendors. 


CHAPTER    XX 

INVESTIGATIONS    (Continued) 


ON   SALE   OR   PURCHASE   OF   A   BUSINESS 
(Continued) 

(f)  Elimination  of  Unusual  Items 

Earnings 

A  purchaser  profits  from  future  business  only.  Large 
special  profits  may  have  been  made  in  the  past,  but  his 
interest  lies  in  the  possible  profits  of  the  future.  Neces- 
sarily these  are  based  largely  on  past  experience,  but  if 
there  are  items  which  probably  will  not  appear  under 
subsequent  conditions,  they  must  be  eliminated  from  that 
part  of  the  report  upon  which  his  opinion  whether  or  not 
to  buy  will  be  formed. 

Income  from  Assets  Not  Taken  Over 

The  auditor,  in  order  to  make  an  intelligent  report, 
must  have  a  copy  of  the  purchase  contract  or  option.  In 
many  cases  there  are  items  which  appear  on  the  books 
which  are  not  included  in  the  purchase  price  and  which 
are  to  be  retained  by  the  vendor.  It  is  important  to  ascer- 
tain whether  any  income  from  assets  of  this  nature  has 
been  included  in  the  current  earnings. 

Interest  on  Deposits 

If  the  bank  balances  have  been  normal,  any  interest 
thereon  should  not  be  eliminated  unless  it  is  known  that 

469 


470 


AUDITING 


the  future  bank  accounts  are  not  to  bear  interest.  Many 
trust  companies  carry  active  business  accounts  and  allow 
interest,  but  are  not  in  as  good  a  position  to  extend  loans 
as  national  and  state  banks. 

Some  firms  carry  many  hundreds  of  thousands  of  dol- 
lars on  deposit  all  the  time,  earning,  perhaps,  2  or  21/^ 
per  cent,  just  because  they  always  want  to  be  ready  for 
an  emergency.  It  is  not  likely  that  anyone  buying  such 
a  business  would  contemplate  the  same  practice. 

Sale  of  Assets 

The  analysis  of  earnings  will  disclose  whether  anything 
has  been  included  which  represents  profit  on  the  sale  of 
a  portion  of  the  capital  assets.  For  instance,  an  old  build- 
ing or  some  land  may  be  sold  at  an  advance  over  the  book 
value.  This  is  clearly  an  extraordinary  profit  and  must 
not  be  included  among  the  earnings. 

The  author  was  called  upon  to  verify  the  earnings  of 
a  concern  and  found  that  among  the  current  earnings 
were  profits  on  the  purchase  and  sale  of  the  company's 
own  preferred  stock. 

Appreciation  of  Assets 

It  is  a  common  error  to  assume  that  an  appreciation 
in  the  value  of  land  or  any  other  fixed  asset  can  offset  the 
depreciation  of  plant. 

If  a  statement  of  earnings  has  been  prepared  from  the 
books,  and  an  appraisal  shows  that  the  assets  are  equal 
to  the  book  value,  but  that  the  land  has  appreciated  in 
value  $100,000  while  the  machinery  has  depreciated 
$100,000,  then  the  amount  of  appreciation  must  be  elimi- 
nated and  treated  as  an  extraordinary  earning  and  the 
depreciation  included  among  the  expenses  and  deducted 
from  earnings. 


INVESTIGATIONS 


471 


Insurance    Profit 

Where  a  fire  has  occurred,  it  may  be  found  that  the 
books  show  that  a  profit  has  been  realized.  This  usually 
occurs  where  book  values  have  been  written  down  to  be 
conservative,  but  the  insurance  has  been  left  undisturbed. 
As  the  assured  is  entitled  to  recover  the  sound  or  replace- 
able value  of  his  property,  he  may  be  collecting  for  obso- 
lete or  abandoned  machinery,  etc.  In  such  case;  as  the 
prospective  purchaser,  in  order  to  be  conservative,  will 
follow  the  same  system  of  charging  off,  and  cannot  depend 
on  a  fire,  the  apparent  profit  cannot  be  included  among 
the  current  earnings. 

Damages  for  Change  of  Grade,  etc. 

Other  extraordinary  receipts  may  arise  out  of  damages 
collected  from  compulsory  change  of  grade,  a  portion  of 
the  premises  being  condemned  for  municipal  or  public 
utility  use,  etc.  These  are  all  unusual  items  and  are  not 
apt  to  recur  in  the  same  business,  so  they  cannot  be  in- 
cluded among  current  earnings. 

Expenses 

There  may  have  been  special  losses  or  expenses  which 
the  prospective  purchaser  can,  or  thinks  he  can,  guard 
against.    These,  too,  must  be  separately  stated. 

Excessive  Reserves 

Just  as  some  men  decline  to  allow  for  known  losses, 
such  as  bad  debts,  depreciation,  etc.,  others  insist  on  writ- 
ing off  all  of  their  furniture  and  fixtures  and  create  exces- 
sive reserves  for  other  wasting  assets. 

Since  the  passage  of  the  Federal  Income  Tax  Law, 
some  corporations  have  entered  excessive  depreciation  in 
their  books.     Upon  a  sale  they  would  hardly  admit  that 


472  AUDITING 

such  charges  were  proper  deductions  from  profits,  and  if 
the  auditor  finds  that  they  are  excessive,  he  will  adjust 
the  accounts  accordingly. 

The  auditor  will  endeavor  to  have  the  reserves  repre- 
sent actual  depreciation  or  prospective  losses.  When 
they  go  beyond  this  they  are  in  reality  part  of  the  surplus 
and  to  be  so  treated. 

Embezzlements 

It  is  to  be  assumed  that  a  prospective  purchaser  wise 
enough  to  employ  a  professional  auditor  to  investigate 
the  business  he  expects  to  buy,  will,  if  he  acquires  the 
business,  bond  all  employees  and  have  the  accounts 
audited  periodically  thereafter,  so  that  any  past  loss 
through  embezzlement  can  be  eliminated  from  the 
expenses. 

Auditors  should  impress  upon  new  executives  the 
value  of  surety  bonds  for  all  employees.  Many  employers 
who  have  postponed  action  for  many  years  never  do  get 
around  to  it,  but  a  new  proprietor  can  insist  on  this  mat- 
ter without  offending  any  sensitive  employee.  Failure  to 
observe  this  precaution  has  entailed  enormous  losses  to 
some  concerns. 

Fire  and  Other  Losses  Not  Insured 

Likewise,  the  purchaser  will  carry  an  ample  line  of  all 
kinds  of  insurance,  so  that  if  there  has  been  a  fire  loss  not 
fully  covered,  or  if  an  employee  has  been  injured  and  no 
liability  insurance  has  been  carried,  or  if  plate-glass  win- 
dows be  broken,  etc.,  etc.,  the  losses  so  sustained  can  be 
eliminated  from  the  current  expenses — which  should  in- 
clude, however,  a  sum  equal  to  the  premiums  on  such 
insurance  as  if  it  had  been  carried. 

Another  form  of  protection  which  prudent  busines§ 


INVESTIGATIONS  473 

men  carry  is  ''profit"  insurance.  This  covers  loss  of  the 
estimated  profit  which  might  have  been  earned  had  no  fire 
occurred.  The  rate  is  about  the  same  as  for  fire  insur- 
ance, which  in  most  manufacturing  plants  is  extremely 
low. 

It  cannot  be  held,  however,  that  an  auditor  can  cer- 
tify that  the  earnings  of  a  certain  business  would  have 
been  a  given  sum  if  a  fire  had  not  occurred.  If  profit 
insurance  had  been  carried,  and  the  face  of  the  policies 
collected,  there  could  be  no  objection  to  stating  the 
source  of  such  receipts,  but  even  then  an  auditor  could 
not  include  the  income  so  derived  among  current  earnings. 

Actions  at  Law 

Where  any  considerable  expenditure  has  been  made 
by  reason  of  a  verdict  or  compromise  arising  out  of  a  suit 
on  contract  or  infringement,  etc.,  it  might  be  that  part  of 
such  payment  would  be  properly  included  among  the 
current  expenses,  but  that  a  part  would  be  appUcable  to 
prior  periods.  The  auditor  must  deal  with  such  items  on 
their  own  merits. 

(g)  Adjustments  and  Qualifications 

Partners'  Salaries 

In  stating  the  accounts  of  a  business  in  connection 
with  a  sale,  it  is  customary  to  eliminate  from  the  expenses 
the  amount  charged  on  the  books  as  partners'  salaries. 
This  may  be  misleading,  particularly  when  the  earnings 
are  shown  in  support  of  an  issue  of  bonds  or  preferred 
stock.  For  instance,  the  statement  may  be  made  that  the 
net  earnings  of  a  partnership  have  averaged  $48,000  per 
annum,  this  being  four  times  the  interest  on  an  issue 
of  $200,000  6  per  cent  preferred  stock.    In  arriving  at  the 


^74  AUDITING 

net  profit,  custom  decrees  that  the  partners'  compensation 
may  be  omitted.  It  is  true  that  unless  mention  is  made 
of  the  amount  it  would  be  difficult  for  anyone  without  a 
knowledge  of  the  facts  to  form  an  opinion  on  the  matter. 
Partners  frequently  pay  themselves  large  periodical  sums 
carried  on  the  books  as  salaries.  Many  others  credit 
themselves  with  about  the  equivalent  of  the  salary  of  a 
manager  or  a  good  salesman,  while  in  many  cases  no  salary 
at  all  is  allowed  for. 

In  the  case  mentioned  it  may  be  expected  that  after 
the  corporation  is  formed,  the  officers  (former  partners) 
will  insist  on  salaries  unless  they  have  stipulated  that  none 
will  be  voted  or  drawn.  Such  stipulation  is  rare,  so  that 
it  would  not  be  unusual  in  a  corporation  of  this  size  for 
salaries  of  $15,000  to  $25,000  to  be  voted  to  the  new 
officers.  This  becomes  a  charge  to  earnings,  and  thereby 
reduces  the  amount  available  for  dividends  on  the  pre- 
ferred stock.  In  other  words,  the  future  net  earnings  will 
be  largely  diminished,  perhaps  half,  through  the  change 
of  name  from  ''partners'  withdrawals"  (not  an  expense)  to 
''officers'  salaries"  (an  expense).  Therefore  a  charge 
should  be  inserted  for  management  salaries.  In  cases  of 
financing  there  is  frequently  some  contract  provision  fix- 
ing the  amount  so  to  be  paid.  In  any  event  an  intelHgent 
estimate  can  and  should  be  made. 

An  auditor  is  never  justified  in  signing  a  certificate 
omitting  partners'  compensation,  unless  the  fact  is  clearly 
stated,  and  any  reference  to  the  bearing  past  earnings  have 
on  a  bond  or  stock  issue  is  quaHfied  by  this  omission. 

Contracts 

If  a  business  is  of  such  a  nature  that  contracts  for  pur- 
chases or  sales  to  be  received  or  delivered  in  the  future  are 
the  custom,  it  will  not  be  sufficient  to  stop  with  the  results 


INVESTIGATIONS 


475 


of  the  last  fiscal  period  unless  the  effect  of  the  contracts 
outstanding  at  that  time  be  considered. 

For  instance,  contracts  may  have  been  entered  into  for 
raw  materials  at  a  high  figure,  and  at  the  time  of  the  ex- 
amination the  market  may  be  much  lower.  The  inventory 
may  have  been  priced  at  the  lower  price,  but  it  is  not 
usual  to  anticipate  a  loss  on  purchase  contracts  not  repre- 
sented by  deliveries. 

If  the  contracts  cannot  be  canceled,  with  the  conse- 
quence that  the  new  period  is  saddled  with  the  necessity 
of  buying  materials  at  an  inflated  price,  the  auditor  will 
have  to  adjust  the  accounts  accordingly.  It  may  be  that 
the  prospective  purchaser  has  full  knowledge  of  the  un- 
favorable agreements,  but  the  auditor  must  not  assume 
this.  If  it  is  stated  that  unfavorable  contracts  for  pur- 
chases or  sales  can  be  canceled,  something  more  than  the 
word  of  an  interested  party  will  be  necessary  to  convince 
the  auditor. 

Taxes 

While  considering  adjustments,  the  subject  of  taxes 
must  be  considered.  It  is  becoming  popular  to  levy  taxes 
on  v/hatever  person  or  thing  will  stand  it.  In  many 
localities  real  estate  taxes  are  increasing  steadily  from  year 
to  year.  At  the  time  of  the  examination,  if  an  assessment 
has  been  made  for  the  following  year,  the  auditor  should 
inspect  it  and  compare  the  amount  payable  thereunder 
with  the  previous  year.  As  there  may  be  an  increase  in 
the  valuation  as  well  as  the  rate,  the  increased  taxes  may 
be  a  sufficiently  large  factor  to  force  a  somewhat  lower 
price  from  the  seller. 

Royalties 

Where  royalties  have  been  paid  under  a  license,  and 


476 


AUDITING 


the  financing  provides  for  the  purchase  of  the  patents  or 
copyrights,  it  may  be  permissible  to  eliminate  from  ex- 
penses the  amounts  paid  in  the  past,  so  far  as  the  possi- 
bilities of  the  future  are  concerned.  But  it  may  be  unsafe 
to  make  the  adjustment  unless  every  detail  of  the  acquisi- 
tion of  the  patents  is  available  and  it  is  found  that  a  clear 
saving  will  result.  Verbal  statements  of  this  nature,  relied 
on  by  auditors,  have  led  to  unfortunate  experiences  in 
the  past. 

The  adjustment  must  include  a  periodical  allowance 
for  the  extinguishment  of  the  price  paid  for  the  patent  or 
copyright. 

The  capitalization,  or  proposed  capitalization,  in  case  of 
a  purchase  must  not  be  confused  with  the  treatment  of 
royalties  in  the  profit  and  loss  statement.  Royalties  paid 
constitute  an  expense,  and  royalties  received  represent 
income.  In  the  former  case  it  is  assumed  that  the  patents 
(if  it  is  out  of  patents  that  the  royalties  arise)  are  not 
owned,  and  in  the  latter  case  that  they  are  owned.  If  the 
patents  are  owned  the  only  income  which  can  arise  directly 
therefrom  is  from  outsiders.  The  concern  itself  receives 
an  equivalent  in  the  form  of  reduced  expenses  by  reason 
of  not  having  to  pay  for  the  use  of  the  patent. 

Orders  of  Public  Service   Commissions 

In  making  investigations  of  public  service  corporations 
operating  within  the  jurisdiction  of  a  public  service  com- 
mission, the  auditor  should  not  fail  to  make  a  thorough 
inquiry  into  the  question  of  whether  any  orders  issued  by 
the  commission  have  not  yet  been  complied  with  by  the 
corporation  whose  accounts  are  the  subject  of  examina- 
tion. CompHance  with  such  orders  might  require  the 
expenditure  of  considerable  sums  of  money — perhaps  for 
purposes  which  will  not  result  in  a  corresponding  increase 


INVESTIGATIONS  4^y 

of  revenue;  instead  of  an  increase  in  revenue,  there  may 
be  only  an  increased  expense  for  maintaining  or  operating 
appliances  required  to  be  installed.  If  the  prospective 
purchaser  had  knowledge  of  the  matter,  he  would  be 
in  a  position  to  protect  himself  when  conducting  negotia- 
tions with  the  seller.  In  the  absence  of  such  knowl- 
edge, however,  he  would  receive  a  severe  shock  on 
being  required,  after  concluding  the  purchase,  to  make  the 
entirely  unexpected  expenditures  necessitated  by  the 
orders  issued  before  his  coming  into  possession  of  the 
property. 

(h)  Errors  in  the  Books 

As  heretofore  stated,  an  investigation  is  an  audit  for  a 
special  purpose.  If  the  special  purpose  is  the  location  of 
errors,  then  the  auditor  will  proceed  as  in  a  regular  audit 
and  nothing  additional  need  be  said.  But  in  other  classes 
of  investigations,  the  question  frequently  arises  as  to  how 
far  the  auditor  should,  or  must,  go  in  order  to  satisfy  him- 
self that  the  accounts  are  correct. 

For  instance,  in  an  inquiry  into  earnings,  it  is  neces- 
sary that  he  should  be  satisfied  that  the  income  is  at  least 
as  much  as  the  aggregate  to  which  he  certifies.  But  sup- 
pose part  of  the  income  which  should  have  been  in- 
cluded has  never  been  carried  into  the  books,  having 
been  misappropriated,  or  lost  through  carelessness  or 
neglect  ? 

As  to  this,  the  opinions  of  professional  accountants 
differ.  Some  say  that  in  investigating  the  profits  of  a 
business  with  reference  to  a  sale,  an  accountant  is  not  ex- 
pected to  check  the  books  and  entries  for  the  purpose  of 
detecting  falsifications,  there  being  a  marked  difference 
between  an  audit  and  an  investigation  with  a  view  to 
profits,   that  some  defalcations  could  not  be  discovered 


478  AUDITING , 

without  verifying  footings,  postings,  and  vouchers,  arid 
that  clients  do  not  desire,  and  are  unwilling  to  pay  for,  a 
detailed  audit.  On  the  other  hand,  it  is  contended  that 
an  auditor  is  not  justified  in  certifying  to  a  balance  sheet 
and  profit  and  loss  account  unless  an  audit  has  been 
made. 

In  the  author's  opinion,  the  test  of  what  should  be 
done  depends  upon  the  nature  of  the  result  to  be  attained. 
If  an  auditor  is  requested  to  examine  the  accounts  of  a 
business  for  a  period  of  years,  to  state  and  certify  to  the 
net  earnings  realized  and  to  the  financial  condition  as  of  a 
certain  date,  then  it  is  proper  to  restrict  oneself  to  the 
actual  work  necessary,  and  additional  work  is  superfluous. 
If  income  or  assets  have  been  omitted,  and  the  omission 
could  not  have  been  detected  unless  a  complete  audit  were 
made,  nevertheless  the  auditor  has  fulfilled  his  duty.  If 
expenses  or  liabilities  have  been  omitted,  the  auditor  can- 
not be  excused  even  if  a  detailed  audit  were  necessary  to 
discover  the  omissions. 

No  examination  along  the  lines  indicated  could  be  con- 
sidered as  complete  in  any  event  unless  intelligent  analyses 
were  made  of  the  various  income  and  expense  accounts. 
Usually  these  analyses  will  disclose  fraud  or  errors  of  prin- 
ciple if  they  exist. 

The  final  test  of  the  sufficiency  of  the  examination  lies 
in  the  skill  with  which  the  work  has  been  handled.  If  the 
auditor  has  brought  to  bear  all  of  the  care  and  skill  which 
might  reasonably  be  demanded  of  an  experienced  prac- 
titioner, then  he  cannot  be  held  morally  or  professionally 
responsible  for  well  concealed  errors  or  omissions,  but  it 
must  be  remembered  that  the  degree  of  care  and  skill 
called  for  is  much  greater  than,  is  expected  or  legally 
demanded  from  an  inexperienced  person  or  one  who  does 
not  hold  himself  out  as  a  professional  auditor. 


INVESTIGATIONS 


479 


(i)  Investigation  on  Behalf  of  a  Retiring  Partner  When  the 
Business  Is  Being  Sold  to  a  Continuing  Partner 

When  the  retirement  of  a  partner  is  caused  by  his 
death  or  by  physical  disability,  a  ''continuing"  partner  may 
also  be  a  ''Hquidating"  partner.  In  such  case  the  con- 
tinuing partner  is  charged  with  a  greater  degree  of  re- 
sponsibility than  that  to  which  the  purchaser  of  a  business 
under  other  circumstances  would  be  held.  The  con- 
tinuing partner  is  in  the  best  position  to  protect  his  own 
interests,  and  the  auditor'3  connection  with  the  liquidation 
of  the  old  firm  will  most  frequently  be  as  representative  of 
the  retiring  partner. 

The  auditor  will  need  to  do  all  the  work  which  is 
usually  included  in  an  investigation  made  for  an  intending 
purchaser,  but  there  are,  in  addition,  certain  other  phases 
of  the  situation  which  should  receive  consideration,  and  it 
is  these  of  which  mention  will  be  made.  It  is  only  equita- 
ble that  the  assets  should  be  valued  on  the  basis  of  a  going 
concern,  and  it  is  clearly  the  duty  of  the  auditor  to  see 
that  they  are  not  undervalued.  It  would  be  most  satis- 
factory to  have  independent  appraisers  employed  to  value 
such  assets  as  plant  and  stock-in-trade,  due  consideration 
being  given  both  to  tHe  circumstances  of  the  case  and  the 
rights  of  each  of  the  partners.  Frequently,  however,  this 
is  not  done,  and  the  business  is  liquidated  by  the  con- 
tinuing partner,  who  himself  values  the  various  assets. 
While  specific  rules  to  be  followed  can  hardly  be  laid 
down,  it  should  be  observed  that  in  cases  of  doubt  as  to 
values  the  absent  partner  should  have  the  benefit  thereof. 
This  is  only  fair,  as  the  surviving  or  continuing  partner  is 
in  a  position  to  secure  what  he  believes  to  be  his  rights, 
whereas  the  retiring  partner,  through  death  or  absence,  is 
not  in  the  same  position  to  urge  the  consideration  of  his 
rights.     It  is  an  estabHshed  rule  of  law  that  a  liquidating 


48o  AUDITING 

partner  must  not  take  advantage  of  his  position,  and  this 
of  itself  is  sufficient  reason  for  his  deciding  all  doubtful 
cases  in  favor  of  the  absent  partner. 

Accounts  receivable  and  any  other  choses  in  action 
should  be  "worked  out."  The  continuing  partner  is  not 
entitled  to  any  commission  for  his  own  services  in  this 
connection,  though  he  should  be  reimbursed  for  the  actual 
expenses  incurred  for  clerical  work  entailed  thereby.  Dis- 
counts and  other  allowances  credited  to  customers  upon 
settlement  of  the  outstanding  accounts  should  be  care- 
fully scrutinized.  Goods  returned  by  customers  subse- 
quent to  the  date  of  dissolution  would  ordinarily  be  taken 
into  the  stock  of  the  new  business,  and,  unless  particular 
attention  is  given  to  this  class  of  transactions,  the  charge 
which  should  be  made  to  the  new  business  and  credited  to 
the  liquidation  of  the  old  might  very  easily  be  overlooked. 
Unless  the  total  amount  involved  is  very  small  indeed,  all 
credits  to  old  customers  other  than  for  cash  should  be 
analyzed.  Those  which  are  for  goods  returned  can  then  be 
made  the  subject  of  further  investigation. 

The  valuation  of  the  stock  on  hand  is  Hkely  to  present 
considerable  difficulty.  The  usual  rule  of  valuing  the  stock 
at  ''market  or  cost,  whichever  is  lower,"  does  not  neces- 
sarily apply  in  such  a  case.  The  liquidating  partner  is 
under  obligation  to  secure  the  largest  return  for  all  the 
assets  of  the  business,  and  he  has  a  right  to  sell  the  stock 
to  himself,  which  he  is  in  efifect  doing,  only  if  he  is  willing 
to  pay  as  much,  or  more,  for  it  than  could  have 
been  secured  from  anyone  else.  This  is  not  to  be  construed 
as  meaning  what  could  have  been  secured  at  a  forced 
sale. 

The  fairest  valuation  would  probably  be  the  cost  of 
duplicating  the  stock  as  of  the  date  of  dissolution,  due 
allowance  being  made  for  obsolete  or  imperfect  stock.     If 


INVEStlGATlONS  481 

the  inventory  includes  only  staple  goods,  little  difficulty 
will  be  encountered  in  ascertaining  the  present  cost  of 
duplicating  them.  If  the  goods,  however,  have  been 
made  to  special  order,  or  are  otherwise  difficult  to  value, 
estimates  could  be  secured  from  manufacturers  for  making 
similar  articles,  or  the  actual  sales  of  the  goods  in  the  in- 
ventory could  be  traced  and  the  customary  rates  of  gross 
profit  applied  to  estimate  the  cost.  These  matters  should 
be  covered  by  an  agreement.  In  drawing  such  a'greements 
the  auditor  should  be  consulted. 

If  it  be  agreed  to  value  the  stock  on  the  basis  of  cost, 
it  is  to  be  remembered  that  this  would  include  not  only 
the  original  purchase  price  of  the  goods,  but  also  freight, 
cartage,  and  any  other  direct  charges  for  handling  and 
placing  the  goods  in  stock.  It  is  sometimes  urged  that 
the  term  "cost"  in  such  a  case  should  include  interest 
from  the  date  of  purchase  to  the  date  of  the  inventory. 
This  does  not  seem  logical,  however,  inasmuch  as,  if  mar- 
ket prices  were  still  the  same  as  at  the  date  the  goods  were 
bought,  the  fact  that  the  goods  had  been  in  stock  a 
number  of  months  would  not  add  to  their  value.  On  the 
contrary,  the  longer  the  goods  had  been  on  hand  the 
greater  the  probability  of  their  already  being,  or  becoming 
at  an  early  date,  unsalable. 

Profits  realized  or  losses  sustained  on  the  completion 
of  contracts  made  prior  to  the  dissolution  of  the  partner- 
ship are  to  be  apportioned  between  the  retiring  and  con- 
tinuing partners.  Inasmuch  as  the  retiring  partner  shared 
in  the  expenses  of  securing  the  contracts  and  participated 
in  the  risk  of  undertaking  them,  it  is  only  fair  that  he 
should  participate  in  the  profits  derived  therefrom.  On 
the  other  hand,  he  should  also  help  to  bear  the  burden  of 
any  losses  sustained  in  carrying  out  contracts  which  were 
made  prior  to  the  dissolution  of  the  partnership.    There  is 


4S2 


AUDITING 


no  reason  why  the  continuing  partner  should  be  called  on 
to  bear  the  burden  alone,  unless  a  specific  agreement  is 
reached  under  which  the  continuing  partner  takes  over 
the  contracts  at  specific  values  and  assumes  all  further  risk 
in  connection  with  their  completion.  To  do  this  it  would, 
of  course,  be  necessary  to  secure  the  consent  of  all  other 
parties  to  the  contracts,  so  that  the  retiring  partner  or 
his  estate  be  released  from  all  liability  for  the  execution  of 
the  contracts. 

Usually  the  most  equitable  method  of  valuing  ma- 
chinery and  fixtures  would  seem  to  be  cost  less  proper 
depreciation  allowances.  If  this  differs  materially  from 
the  cost  of  reproduction  at  the  present  time  (also  making 
allowance  in  this  case  for  accrued  depreciation),  the  valu- 
ation will  probably  have  to  be  made  the  subject  of  com- 
promise between  the  parties. 

While  the  correctness  of  the  balance  sheet  is  of  pre- 
eminent importance  in  an  investigation  such  as  the  one 
under  consideration,  the  correctness  of  the  income  ac- 
count is  likewise  of  importance  if  the  good-will  is  to  be 
valued  on  the  basis  of  past  earnings.  It  is  also  necessary 
to  review  the  expenses  entering  into  the  income  account 
for  a  period  prior  to  the  date  of  dissolution  so  as  to  see 
that  no  prepaid  expenses  which  would  apply  subsequent 
to  the  date  of  dissolution  have  been  absorbed  by  the  old 
business.  The  retiring  partner  will,  in  due  course,  be 
debited  with  his  proportion  of  all  expenses  chargeable  to 
the  old  firm,  even  though  they  may  not  have  appeared 
among  the  liabilities  stated  on  the  books  at  the  time  of  his 
retirement.  Prepaid  expenses  applying  to  the  new  busi- 
ness would  not,  however,  be  so  likely  to  be  brought  into 
the  liquidation  account  if  they  were  absorbed  in  the  opera- 
tions of  the  old  firm. 

There  are  still  other  questions,  such  as  partners'  salaries 


INVESTIGATIONS 


483 


and  interest  on  partners'  accounts,  which  will  need  to  be 
carefully  considered  in  the  light  of  the  partnership  agree- 
ment. 

(j)  Investigation  for  Those  in  Charge  of  Reorganizations 

There  is  an  increasing  demand  for  the  services  of  ac- 
countants in  connection  with  reorganizations.  The  special 
features  of  such  examinations  are  admirably  expressed  by 
A.  Lowes  Dickinson,  C.P.A.,  in  his  work  "Accounting 
Practice  and  Procedure"  (page  245)  : 

The  consideration  of  a  plan  for  the  reorganization  of  a  property 
which  has  been  reduced  to  a  condition  of  insolvency  requires  a  full  and 
accurate  knowledge  of  all  the  existing  conditions  with  regard  to  the 
property  and  its  past  and  probable  future  earning  capacity.  The 
elements  to  be  investigated  and  determined  will,  therefore,  be  as  follows  : 

1.  The  sources  and  nature  of  the  gross  earnings  and  the  prospects 
of  any  increase  therein  without  further  expenditures  for  development. 

2.  The  cost  of  operation,  with  particular  reference  to  the  effect 
thereon  of  bad  management  or  bad  organization,  and  to  the  possi- 
bility of  remedying  these  conditions;  and  the  proportion  which 
the  cost  of  operation  has  borne  and  may  be  expected  to  bear  to 
the  gross  earnings. 

3.  A  comparison  of  the  gross  and  net  earnings  and  capitaliza- 
tion of  the  property,  with  some  actual  or  desirable  standard,  so  as 
to  determine  the  proportion  which  one  should  bear  to  the  other  if 
the  reorganization  is  to  prove  successful. 

4.  Hence  to  arrive  at  the  total  interest-bearing  and  dividend- 
paying  capital,  which  the  reorganized  property  will  stand  on  some 
fixed  interest  basis. 

5.  The  rank  of  the  different  classes  of  obligations  having  re- 
gard to  the  property  pledged  as  security  therefor;  the  margin  of 
security;  the  rate  of  interest;  the  date  of  maturity;  the  equivalent 
par  value  on  the  basis  of  the  standard  rate  of  interest  adopted  for 
all  classes;  and,  if  practicable,  the  extent  to  which  the  properties 
specifically  mortgaged  show  sufficient  earnings  to  meet  interest  on 
the  indebtedness  secured  thereon.  This  class  of  information  will 
probably  require  a  report  from  an  engineer  or  other  expert  on  the 
value  and  the  condition  of  the  physical  property. 

6.  Following  upon  the  determination  of  these  factors,  a  con- 
sideration  of   the  various   separately  mortgaged   divisions   of  the 


484  AUDITING 

property,  with  a  view  to  determining  whether  any  should  be  aban- 
doned to  the  bondholders,  rather  than  be  included  in  a  reor- 
ganization. And  here  it  is  important  to  observe  that  the  contribu- 
tion of  any  specific  piece  of  property  to  the  general  organization 
is  not  necessarily  measured  by  its  ability  by  itself  to  earn  interest 
on  the  obligations  secured  thereon.  Numerous  other  factors  will 
enter  into  a  consideration  of  this  point,  and  it  may  easily  appear 
that  a  property  earning  little  or  nothing  toward  payment  of  its 
obligations  is  sufficiently  valuable  to  the  organization,  as  a  whole, 
to  be  retained,  if  possible. 

7.  Another  important  factor  is  the  amount  of  new  money  re- 
quired to  be  introduced  for  the  purpose  of  paying  off  the  floating 
debt  and  rehabilitating  the  property,  and  the  best  method  of  raising 
such  money,  whether  by  the  issue  of  new  prior  lien  securities  rank- 
ing in  front  of  or  on  an  equality  with  those  issued  in  exchange  for 
existing  mortgages,  or  by  assessments  on  junior  classes  of  securi- 
ties. In  the  latter  case  it  is  important  that  sufficient  inducement  be 
given  to  the  junior  classes,  in  the  proportion  of  new  securities 
issued  for  old,  to  induce  them  to  pay  these  assessments;  while  for 
the  assessments  themselves,  the  securities  issued  should  represent 
the  par  value  of  the  cash  paid  in  on  some  reasonable  market  valuation. 

2.  INVESTIGATION  FOR  CREDITORS,  ETC. 

Auditors  are  frequently  called  upon  to  make  examina- 
tions the  scope  of  which  is  practically  limited  to  certain 
accounts  about  which  the  most  complete  detail  is  re- 
quired. For  instance,  a  manufacturer  may  desire  to  ex- 
tend a  large  line  of  credit  to  a  jobber  or  merchant,  and 
before  doing  so  wants  to  know  the  latter's  capacity  for 
handling  his  line,  as  well  as  to  know  that  his  financial  con- 
dition and  method  of  doing  business  are  satisfactory. 

Investigation  on  Behalf  of  a  Present  or  Prospective  Creditor 

Examinations  along  these  lines  may  be  divided  into 
two  general  classes: 

For  bankers  or  note  brokers  who  propose  to  loan  on 
the  promissory  notes  of  the  borrower,  or  for  bank- 
ers who  propose  to  bring  out  bond  or  preferred 
stock  issues. 


INVESTIGATIONS  485 

For  individuals  or  business  concerns  who  propose  to 
make  advances  for  various  purposes,  or  who  have 
extended  or  who  expect  to  extend  credit  on  open 
account. 
In  the  main,  the  points  to  be  observed  have  been  dis- 
cussed in  the  chapters  on  the  conduct  of  a  balance  sheet 
audit,  but  there  are  certain  special  precautions  which  may, 
with  propriety,  be  enlarged  upon  at  this  time. 

(a)  Examinations  for  Bankers 

Extension  of  Business 

The  most  important  line  of  examination,  after  ascer- 
taining the  assets  and  liabilities  and  analyzing  the  profit 
and  loss  account,  is  an  inquiry  into  the  plans  for  the  future 
which  have  been  adopted  or  which  are  under  considera- 
tion. The  average  business  man  is  not  content  with  a 
stationary  business.  He  wishes  to  expand  for  the  purpose 
of  increasing  his  profits,  decreasing  his  expense  ratio,  and 
perhaps  the  most  compelling  of  all  reasons  is  his  ambition 
to  outstrip  his  competitors. 

If  his  floating  debt  has  been  burdensome,  he  may  have 
been  obliged  to  keep  within  certain  bounds  as  to  capacity 
and  production,  but  the  moment  he  is  financed  it  seems 
almost  inevitable  that  new  liabilities  are  incurred  sufficient 
to  use  up  the  additional  supply  of  credit  almost  before  it 
is  available. 

Accountants  do  not  always  feel  concerned  with  this 
phase  of  business  life,  but  as  the  lender  should  have  some 
means  of  determining  the  use  to  which  his  money  is  to  be 
put  other  than  that  supplied  or  promised  by  the  borrower, 
he  naturally  looks  to  the  professional  auditor.  True,  he 
has  looked  in  vain  in  many  cases,  and  this  may  explain  the 
reason  why  so  many  banks,  bankers,  and  financiers  hav§ 


486 


AUDITING 


secured  the  services  of  men  who  can  secure  and  impart  the 
information  required,  irrespective  of  the  fact  of  whether  or 
not  they  have  the  degree  of  Certified  PubUc  Accountant. 

Collateral  v.  Integrity 

Which  is  better,  to  loan  money  to  a  dishonest  man  on 
ample  security,  or  to  a  perfectly  honest  man  who  wishes 
to  borrow  on  his  own  name  and  who  cannot  furnish  col- 
lateral? The  former  may  seem  to  be  more  advisable,  but 
there  are  disadvantages  in  doing  any  business  whatever 
with  a  man  who  cannot  be  trusted. 

In  a  Federal  investigation,  the  late  J.  P.  Morgan  testi- 
fied: 

Credit  is  personal.  Money  can't  buy  credit  Men  can  borrow 
money  who  have  most  limited  properties.  The  first  thing  they 
want  is  their  record.  Money  is  loaned  on  collateral,  of  course,  but 
I  would  not  lend  a  dollar  to  a  man  whom  I  could  not  trust,  if  he 
came  to  me  with  all  the  government  bonds  in  Christendom. 

Therefore,  no  matter  how  good  the  collateral  may  be, 
the  banker  wants  more  information,  and  the  auditor  may 
be  able  to  furnish  it.  Facts  relative  to  previous  business 
experiences,  possible  failures  or  embarrassments  caused  by 
speculation,  etc.,  will  be  secured  from  the  mercantile  agen- 
cies, but  inside  information  relative  to  the  personnel  of 
the  organization  can  be  furnished  by  the  auditor. 

Experience  has  demonstrated  that  where  partners 
quarrel,  or  where  one  does  all  the  work,  trouble  will  follow. 
Large  concerns,  solvent  so  far  as  finances  go,  have  been 
placed  in  the  hands  of  receivers  because  of  internal  dissen- 
sions. A  banker  does  not  want  to  make  a  loan  which  may 
be  paid  off  eventually  by  a  receiver,  even  if  the  assets  are 
double  the  liabilities. 

Then  one  or  more  departments  of  the  business  may  be 
weak.  The  sales  force  may  be  highly  organized  and  ef^- 
cient,  but  if  the  manufacturing  department  is  poorly  man- 


INVESTIGATIONS  '  487 

aged,  or  is  not  co-ordinated  with  the  sales  department, 
the  results  will  not  be  satisfactory. 

If  no  criticism  is  justified  and  a  man's  honesty  is  un- 
questioned, a  banker  may  prefer  the  risk  to  the  apparent 
safety  of  a  loan  secured  by  collateral.  It  has  been  said 
that  ''a  crooked  borrower  is  always  a  wise  window- 
dresser,"  and  this  observation  may  be  enlarged  to  remind 
the  banker  that  crooked  borrowers  when  negotiating  a 
loan  sometimes  offer  collateral  to  which  they  do  not 
have  title. 

Future  Business 

During  the  progress  of  any  audit  which  comprehends 
a  balance  sheet,  there  should  be  available  full  data  with 
respect  to  future  business  and  the  means  whereby  it  is 
proposed  to  finance  it. 

Schedules  of  orders  booked,  the  time  estimated  to 
complete  same,  the  cost  of  the  raw  materials,  labor,  and 
other  manufacturing  expenses,  the  time  within  which  the 
proceeds  of  sales  will  mature,  the  dates  by  which  the  lia- 
bilities for  purchase  will  have  to  be  discharged,  and  many 
other  factors  are  all  to  be  compiled  and  put  into  readable  and 
dependable  form. 

If  funds  are  to  be  furnished  to  meet  pressing  obliga- 
tions, and  if  any  increase  in  the  business  means  the  tying 
up  of  additional  cash  for  a  considerable  period,  then  there 
may  be  a  hesitancy  about  supplying  the  needs  unless  a 
stipulation  is  furnished  that  additional  business  will  not  be 
sought  until  the  funds  with  which  to  finance  it  are  in 
sight.  The  auditor  who  can  secure  information  of  this 
nature  may  be  helpful  to  the  banker  and  even  more  so  to 
the  borrower,  for  it  is  of  no  permanent  advantage  to  the 
latter  to  be  tided  over  one  period  of  stringency  merely  to 
be  plunged  into  another  and  more  serious  situation, 


488 


AUDITING 


Bank  Loans  to  be  Repaid 

The  auditor  must  bear  in  mind  that  the  banker  whom 
he  represents  in  these  investigations  is  considering  the 
investment  of  deposits  which  are  chiefly  payable  on  de- 
mand, therefore  he  is  not  contemplating  the  making  of  a 
permanent  loan,  but  one  which  will  be  repaid  within  a 
comparatively  short  period  of  time.  If  a  banker  were 
looking  purely  for  security,  he  would  invest  a  large  por- 
tion of  his  funds  in  real  estate  mortgages.  The  security 
might  be  better  than  commercial  paper,  but  the  maturities 
would  be  from  one  to  three  years,  and  hence  entirely  un- 
suitable for  his  purposes. 

If  the  auditor  ascertains  that  the  prospective  borrower 
does  not  expect  to  "clean  up"  at  least  once  a  year,  he 
should  so  report  to  his  client. 

(b)  Investigations  After  Bankruptcy 

Auditors  are  frequently  called  upon  by  creditors  or 
other  interested  parties  to  make  investigations  of  bank- 
rupt or  insolvent  concerns  and  to  report  upon  their  con- 
dition and  the  causes  of  insolvency.  The  detailed  work  of 
examinations  of  this  class  is,  in  the  main,  quite  similar  to 
that  in  connection  with  a  regular  audit.  Certain  features, 
however,  call  for  special  attention. 

These  examinations  fall  into  two  general  divisions : 

1.  To  serve  as  a  basis  for  intelligent  action  by  a  cred- 

itors' committee  in  connection  with  the  filing  of  a 
petition,  a  possible  extension  of  time,  or  prepara- 
tory to  the  liquidation  of  the  business  of  the  bank- 
rupt. 

2.  To  furnish  information  and  assistance  incidental  to 

a  proper  consideration  of  an  offer  of  composition 
or  other  settlement. 


INVESTIGATIONS 


489 


In  respect  of  the  former,  the  auditor  must  guard 
against  inflated  assets,  and  understated  and  omitted  liabili- 
ties, whereas  in  the  latter  case  the  reverse  conditions  must 
be  looked  for.  The  greatest  care  should  be  exercised  in 
the  verification  of  the  assets  and  liabilities,  and  docu- 
mentary evidence  in  support  thereof  should  be  obtained 
wherever  possible.  A  good  plan  is  to  secure,  if  possible, 
statements  rendered  by  the  bankrupt  to  credit  agencies, 
say,  a  year  or  so  prior  to  the  date  of  examination.  A  com- 
parison thereof  with  the  books  might  possibly  indicate 
some  assets  which  do  not  appear  on  the  latter. 

The  detailed  examination  should  extend,  at  least,  over 
the  period  during  which  preferential  transfers  or  payments 
might  have  been  made.  These  would  consist  of  transfers 
of  property  while  insolvent,  with  intent  to  hinder,  delay,  or 
defraud  creditors;  or  with  the  intention  to  prefer  one  cred- 
itor over  others  of  the  same  class.  Transfers  of  property 
without  compensation,  or  at  unreasonably  low  valuations 
should  be  carefully  investigated  and  scheduled,  and  special 
attention  directed  thereto  in  the  report. 

The  accounts  should  be  carefully  examined  for  pre- 
dated payments  to  creditors,  chattel  mortgages  on  mer- 
chandise, and  payments  to  creditors  charged  to  expense 
accounts,  as  preferences  are  sometimes  effected  in  this 
manner. 

Wherever  the  identity  of  the  merchandise  can  be  es- 
tablished by  numbers,  trade-marks  or  other  symbols,  it 
would  be  advisable  to  trace  the  largest  items  in  verifica- 
tion of  the  inventory  totals.  This  might  also  disclose 
shortages  of  goods  of  such  amounts  as  to  support  the 
inference  that  goods  were  shipped  out  to  friends  or  rela- 
tives.   Instances  of  this  kind  are  of  frequent  occurrence. 

Where  the  examination  is  made  in  connection  with  a 
proposed  settlement,  inventory  valuations  should  be  very 


490  AUDITING 

carefully  verified.  Instances  are  known  where  undervalu- 
ation was  attempted  by  employing  excessively  low  prices. 
Goods  stated  to  be  of  no  value  because  of  alleged  damage 
should  be  called  for  and  inspected.  If  necessary  the  ser- 
vices of  an  expert  appraiser  should  be  had  for  this  purpose. 
Misstatement  of  inventories  is  more  frequently  attempted 
than  is  the  case  with  other  assets,  possibly  because  detec- 
tion thereof  is  more  difficult.  The  auditor,  therefore,  must 
be  especially  vigilant  in  this  regard. 

It  is  extremely  important  to  vouch  cash  payments 
during  the  period  selected  for  review.  This  is  especially 
true  of  all  large  amounts. 

In  a  bankuptcy  case  of  recent  date  it  was  found  that 
cheques  were  drawn  to  the  order  of  various  employees 
who  posed  as  creditors.  The  cheques  were  duly  cashed 
and  the  proceeds  eventually  paid  over  to  the  partners  of 
the  concern  in  question. 

A  critical  scrutiny  of  the  receipts  and  payments  for 
unusual  items  may  sometimes  disclose  the  existence  of  a 
silent  partner,  as  evidenced  perhaps  by  interest  payments 
or  remittances  for  profits,  etc. 

The  accounts  receivable  should  be  analyzed,  and  pe- 
riodized,  and  set  forth  on  the  statements,  classified  as  to 
good,  doubtful,  and  bad.  All  the  accounts  should,  if  pos- 
sible, be  confirmed  by  correspondence.  Accounts  with 
large  balances,  said  to  be  uncollectable,  should  be  regarded 
with  suspicion  and  subjected  to  independent  verification. 
Inquiry  among  other  houses  in  the  same  line  of  business 
may  result  in  the  auditor's  finding  that  some  of  the  alleged 
doubtful  accounts  are  good. 

Accounts  with  salesmen  covering  goods  in  hand,  either 
as  samples  or  for  sale,  also  cash  advances  for  expenses, 
commissions,  etc.,  should  receive  careful  attention.  These 
accounts  are  frequently  stated  to  be  worthless  in  order  to 


INVESttGAtlONS 


491 


make  a  poor  showing  and  thereby  to  induce  the  creditors 
to  accept  an  unfavorable  settlement.  Commissions  due  to 
salesmen  should  be  verified  by  reference  to  the  sales  rec- 
ords, and  by  an  inspection  of  the  salesmen's  contracts,  if 
any  exist.  The  auditor  should  satisfy  himself  that  the 
commissions  stated  as  due  have  accrued  on  actual  sales 
and  that  the  respective  salesmen  are  entitled  thereto. 

With  reference  to  accounts  payable,  the  auditor  should 
be  certain  that  all  items  are  included  and  that  the  re- 
spective amounts  recorded  as  due  are  actually  owing.  He 
should  also,  as  far  as  possible,  establish  the  propriety  of 
claims  presented  and  endeavor  to  provide  for  all  possible 
claims  not  received  at  the  time  statements  are  submitted. 
The  statements  usually  prepared  consist  of  a  statement  of 
affairs,  with  supporting  schedules,  and  a  deficiency  ac- 
count. If  the  auditor  is  still  in  charge,  in  cases  where 
there  is  a  final  winding  up  of  affairs,  a  statement  of  realiza- 
tion and  Hquidation  is  prepared. 

It  is  essential  in  this  class  of  examinations  for  the  audi- 
tor to  verify  and  account  for  all  the  assets  and  liabilities 
that  appear  on  the  books,  and  to  estabUsh  the  possible 
existence  of  assets  and  liabilities  not  revealed  in  the  ac- 
counts. He  must  be  extremely  conservative  in  estimating 
the  realizable  values,  always  keeping  in  mind  that  his  re- 
port will,  in  all  probability,  be  reHed  upon  by  the  creditors, 
and  that  a  too  optimistic  report  results  in  disappoint- 
ments that  reflect  on  his  accounting  ability. 

(c)  Investigation  for  Purely  Credit  Purposes 

The  credit  manager  of  a  business  concern  or  the  repre- 
sentative of  a  capitalist  who  contemplates  extending 
credit  to  a  prospective  borrower  or  debtor  must  proceed 
along  somewhat  different  lines  than  the  professional  audi- 
tor, whose  duty  is  to  report  upon  actual  conditions,  and 


^^^  AUDITING 

Upon  whom  the  responsibiUty  is  not  laid  of  having  to  de- 
termine immediate  action,  based  more  on  the  estimated 
outcome  of  the  future  than  on  present  financial  strength. 

For  instance,  an  auditor  might  ascertain  and  report 
that  a  certain  man  had  cash  on  hand  of  $100,000  and  no 
debts.  He  would  have  no  further  responsibility  there- 
after, unless  it  were  shown  subsequently  that  there  were 
undisclosed  liabilities.  We  will  assume,  however,  that  the 
facts  were  as  reported. 

The  credit  manager  might  have  an  entirely  different 
task  before  him.  He  should  use  the  same  means  to  ascer- 
tain that  the  $100,000  was  actually  on  hand  and  free  from 
Hens,  and  that  there  were  no  liabilities,  but  his  work  would 
then,  in  a  sense,  be  merely  beginning.  He  should  ascer- 
tain the  past  and  present  moral  and  business  reputation 
of  the  man;  he  should  have  an  accurate  and  complete  his- 
tory of  his  business  career;  he  should  question  him  in 
detail  as  to  what  he  intends  to  do  with  the  money; 
whether  his  proposed  business  venture  calls  for  a  capital 
of  more  than  $100,000,  and  so  on. 

It  has  been  said  that  the  credit  manager  must  always 
look  out  for  three  essential  elements  in  passing  on  a  credit 
basis,  viz.,  character,  capital,  and  capacity,  three  "C's,'* 
and  therefore  easily  remembered. 

The  author  feels  that  there  are  so  many  points  of  con- 
tact between  a  professional  auditor  and  a  credit  manager 
that  this  opportunity  should  be  taken  to  discuss  the  simi- 
larities of  their  work,  with  a  view  to  standardizing  as  much 
of  it  as  possible. 

It  is  not  contended  that  the  auditor  should  attempt  all 
the  manifold  duties  of  the  credit  manager,  nor  that  the 
latter  should  burden  himself  with  the  technical  knowledge 
required  to  make  a  detailed  audit.  It  is,  however,  urged, 
without  fear  of  contradiction,  that  an  auditor  would  be 


INVESTIGATIONS 


493 


able  to  render  better  service  to  his  clients  if  he  could  ac- 
quire some  of  the  instincts  of  the  successful  credit  man- 
ager and  keep  constantly  before  him,  when  making  inves- 
tigations involving  proposed  credits  or  investments,  many 
of  the  requirements  which  the  science  of  credits  has  found 
to  be  essential.  Likewise,  who  will  deny  that  the  credit 
manager  could  perform  his  work  more  easily  and  scien- 
tifically if  he  were  conversant  with  the  principles,  and 
could  take  advantage  of  the  experience,  underlying  the 
practice  of  professional  auditing? 

The  National  Association  of  Credit  Men's  bulletins 
contain  this: 

The  giver  of  credit  is  a  contributor  of  capital,  and  becomes,  in 
a  certain  sense,  a  partner  of  the  debtor,  and,  as  such,  has  a  perfect 
right  to  complete  information  of  the  debtor's  condition  at  all 
times. 

Credit  is  given  a  merchant  because  of  the  confidence  reposed 
in  him.  Requesting  a  statement  when  credit  is  asked  is  not  a 
reflection  on  one's  character,  honesty,  or  business  ability,  but  is 
done  to  secure  information  to  enable  business  to  be  conducted 
intelligently. 

When  a  statement  is  made  it  should  be  absolutely  correct.  To 
make  it  so  necessitates  the  taking  of  at  least  an  annual  inventory 
and  the  keeping  of  an  accurate  set  of  books.  Statement  giving, 
therefore,  will  tend  to  make  a  debtor  a  better  buyer,  because  more 
familiar  with  his  stock,  more  careful  in  giving  credit,  more  con- 
servative in  incurring  debt,  and  will  result  in  a  better  knowledge 
of  his  business  generally. 

A  merchant  who  desires  to  serve  his  own  best  interests  should 
recognize  that  his  most  valuable  possession,  apart  from  his  actual 
assets,  is  a  sound,  substantial  and  unquestioned  reputation  as  a 
credit  risk,  and  that,  under  the  prevailing  conditions  and  demands 
of  business,  the  most  eflFective,  and  eminently  the  best  way  to 
prove  his  basis  for  credit  is  to  be  willing  to  submit  a  statement  of  his 
financial  condition. 

The  liabilities  in  business  failures  aggregate  over 
$200,000,000  per  annum,  the  loss  to  creditors  being  more 
than   half   that   amount,   and   the  number   of  failures   is 


494  AUDITING 

steadily  increasing.  In  a  very  large  proportion  of  these 
cases  credit  could  not  be  secured  if  the  debtor  were  obliged 
to  submit  his  books  to  an  examination  by  a  professional 
auditor. 

Is  it  unreasonable  to  suppose  that  the  general  use  of 
auditors  to  verify  the  accounts  of  concerns  seeking  credit 
would  save  ten  per  cent  of  this  annual  loss  of  over 
$100,000,000?  If  a  saving  of  over  ten  millions  of  dollars 
could  be  effected  by  the  expenditure  of,  say,  one  million, 
would  it  not  be  worth  while  to  attempt  to  save  another  10 
per  cent  or  more  by  compulsory  audits  of  all  concerns  seek- 
ing credit  ? 

It  is  a  great  surprise  to  credit  managers  when  they 
realize  losses  from  respected  concerns — those  concerns 
whose  statements  the  bankers  and  credit  men  do  not  verify 
personally,  nor  cause  to  be  verified  by  some  independent 
means. 

It  is  because  credit  managers  do  not,  as  a  rule,  recog- 
nize the  fact  that  most  concerns  cannot  be  depended  upon 
to  furnish  a  true  statement  of  their  financial  condition. 
Aside  from  fraud,  inaccuracies  (which  are  just  as  expensive 
as  fraud)  arise  from  the  following  causes : 

1.  The  fallibility  of  human  nature,  which,  with  respect 

to  financial  statements,  leads  to  optimism,  the  mak- 
ing the  best  of  things,  which  inevitably  leads  to 
the  perhaps  unconscious  overstatement  of  assets, 
and  understatement  of  liabilities. 

2.  The  inevitable  errors  which  arise  in  the  use  of  esti- 

mates, honest  errors,  but  errors  which  almost 
always  result  in  an  overstatement  of  net  worth. 

3.  Ignorance  of  executives  and  clerks,  inefficient  meth- 
ods and  systems,  resulting  in  misleading  statements 
of  financial  condition.  Strange  to  say,  such  state- 
ments nearly  always  overstate  net  worth. 


INVESTIGATIONS  495 

4.  Consciousness  of  weak  spots,  but  coupled  with  a 
mental  reservation  to  adjust  them  later. 

If  we  can  agree  that  the  factors  named  are  of  sufficient 
importance  to  warrant  an  independent  verification;  if  it  is 
true  that  for  his  own  sake,  as  well  as  for  the  benefit  of  the 
dispenser  of  credit,  the  seeker  for  credit  should  have  his 
statement  verified,  how  is  it  to  be  done? 

The  answer  to  this  question  is  simple.  It  may  be  ac- 
complished by  proper  recognition  on  the  part  of  the 
credit  manager  of  the  value  of  verified  financial  statements 
and  insistence  upon  the  practice;  and  by  a  proper  recogr 
nition  on  the  part  of  the  professional  auditor  of  the  point 
of  view  of  the  credit  manager.  The  responsibility  will 
then  rest  upon  the  auditor  for  audit  certificates  which  can 
be  depended  upon. 

Unscientific  Methods 

Such  methods  afifect  business  success  quite  as  much  as 
anything  else.  The  auditor  may  find  a  satisfactory  surplus 
of  assets,  but  if  carelessness  or  incompetence  exists  in  the 
accounting  and  other  departments,  a  day  of  reckoning 
will  surely  arrive. 

Signs  of  carelessness  or  incompetence  may  be  found  in 
lax  collection  methods.  More  than  one  failure  has  re- 
sulted from  a  policy  of  allowing  collections  to  take  care  of 
themselves. 

The  precise  procedure  followed  should  be  ascertained 
and  reduced  to  writing.  The  "follow-up"  system  must  be 
examined  very  carefully.  It  may  be  that  the  system  is 
good,  but  that  it  is  not  being  followed.  Then  the  relation 
between  the  departments  must  be  looked  into.  Co-ordi- 
nation here  is  absolutely  essential  to  success.  Sometimes 
a  credit  department  will  claim  that  the  salesmen  arc  so 
anxious  to  sell  that  a  considerable  part  of  the  business 


496 


AUDITING 


must  be  refused.  This  brings  up  the  question  of  co-ordi- 
nation among  the  various  departments  of  a  business.  If  it 
is  lacking,  one  of  the  elements  of  failure  is  present. 

An  investigation  into  the  methods  of  doing  business 
thus  becomes  a  necessity  where  one  is  looking  into  the 
future  probabilities  of  success  or  failure.  Almost  anyone 
can  sell  goods,  but  to  insure  financial  success  they  must  be 
sold  at  a  price  which  will  yield  a  satisfactory  profit  and  to 
customers  who  will  pay.  Here  again  the  methods  of  the 
prospective  debtor  are  all-important,  and  the  representa- 
tive of  the  lender  or  creditor  not  only  has  the  right  to 
know  whether  or  not  scientific  methods  are  in  force,  but 
it  is  his  positive  duty  to  ascertain  whether  or  not  such 
is  the  case. 

Lack  of  Capital 

It  is  said  that  more  failures  result  from  lack  of  capital 
than  from  any  other  cause.  It  may  seem  superfluous  to 
state  that  it  is  better  to  do  a  small  but  safe  and  profitable 
business  than  to  attempt  to  trade  beyond  the  limits  of 
capital  employed;  but  this  overstretching  is  going  on  all 
the  time.  It  is  a  point  on  which  the  auditor  and  credit 
manager  can  secure  accurate  information  from  the  balance 
sheet,  but  this  must  be  supplemented  by  an  inquiry  into 
plans  for  extensions  to  plant,  commitments  for  large 
purchases  for  future  delivery,  and  similar  negotiations. 

Credit  Risks 

The  passion  of  a  salesman  is  to  sell;  the  dread  of  a 
credit  manager  is  to  pass  a  credit  which  will  produce  a 
loss.  Between  the  two  may  He  the  secret  of  a  successful 
business  and  large  profits.  The  burden  is  upon  the  credit 
manager,  and  he  cannot  escape  it  by  turning  down  every 
order  about  which  any  doubt  exists. 


Investigations  497 

The  conclusions  upon  which  he  will  base  his  final  deci- 
sion in  any  case  are  dependent  upon  so  many  different 
circumstances  that  they  cannot  be  enumerated  here,  but 
it  may  be  mentioned  that  the  margin  between  the  cost 
and  selling  price  of  an  article  is  one  of  the  most  important 
factors  to  be  considered  when  the  question  of  the  accept- 
ance or  rejection  of  an  order  is  to  be  settled.  If  the  gross 
profit  is  large,  it  is  obvious  that  more  risk  may  be  taken 
than  where  the  margin  of  profit  is  too  small  to  admit  of 
any  material  amount  being  set  aside  for  bad  debts. 

In  some  lines  the  gross  profit  is  so  large  that  it  would 
be  more  economical  to  sell  everybody  than  to  maintain  a 
credit  department;  in  others  it  is  equally  unnecessary  to 
maintain  such  a  department,  because  all  goods  must  be 
shipped  sight  draft  against  bill  of  lading.  The  point 
seems  obvious,  yet  many  accountants  and  credit  managers 
do  not  differentiate  between  the  rules  to  be  observed, 
which  makes  their  general  advice  of  little  or  no  value. 

Insurance 

A  professional  auditor  does  not  always  inquire  into 
the  sufficiency  of  insurance  of  all  descriptions,  but  it  is 
believed  that  the  successful  credit  manager  has  this  con- 
stantly in  mind.  Auditors  now  see  the  importance  of  this 
line  of  inquiry,  and  among  certain  firms  it  is  an  integral 
part  of  the  audit  program. 

Fire  insurance  is  only  one  of  the  lines  which  should 
be  investigated.  If  the  personality  of  a  partner  or  an  em- 
ployee is  of  great  value,  life  insurance  might  be  desirable. 
Except  in  a  very  few  lines  of  business,  such  as  railway  or 
taxicab,  a  reasonable  amount  of  liability  insurance,  both 
public  and  employers',  should  always  be  carried. 

Profit  insurance  is  frequently  as  important  as  fire 
insurance,   especially   where  a  seasonal  'business   is   con- 


498 


AUDITING 


ducted,  and  large  preliminary  expenses,  such  as  advertis- 
ing, are  incurred,  and  where  a  total  loss  would  result  if  a 
factory  were  to  be  destroyed. 

Errors  of  Principle 

It  is  not  enough  that  a  concern's  financial  statement 
shall  look  well,  for  sometimes  actual  conditions  are  con- 
cealed through  errors  in  bookkeeping.  This  state  of 
things  exists  in  more  cases  than  is  generally  known. 

For  instance,  in  a  contracting  business  the  book- 
keeper, in  closing  the  accounts,  closed  all  of  the  credit 
balances  in  individual  contract  accounts  to  profit  and 
loss.  He  did  not  realize  that  all  of  them  were  not  com- 
pleted and  that  a  considerable  liability  existed  in  respect 
of  the  cost  of  completion.  His  balance  sheet  showed  a 
much  better  financial  position  than  the  concern  deserved, 
but  the  bookkeeper  maintained  that  it  was  correct  until 
he  was  shown  how  inaccurate  it  was. 

Errors  may  be  honestly  made,  and  yet  they  will  bring 
ruin  on  a  concern  unless  discovered  and  rectified.  Failure 
to  provide  for  depreciation  is  the  most  common  derelic- 
tion, and  excessive  charges  to  asset  accounts  is  a  close 
second.  The  auditor  is  always  on  the  lookout  for  such 
errors,  whether  intentional  or  unintentional,  but  few  credit 
managers  realize  the  importance  of  ascertaining  whether 
or  not  the  books  of  a  prospective  debtor  have  been  regu- 
larly examined  by  a  public  accountant. 

Fraud 

Under  this  class  the  auditor  will  find  far  too  many 
examples.  The  bankruptcy  courts  are  full  of  cases  in 
which  creditors  have  been  grossly  deceived.  Many  of 
these  are  so  flagrant  that  it  seems  impossible  that  the 
debtor  should  have  been  able  to  incur  such  large  debts, 


INVESTIGATIONS  ^gg 

yet  the  fact  is  obvious  that  credit  managers  by  the  hun- 
dred and  business  concerns  by  the  thousand  extended 
credit  to  these  bankrupts  to  an  aggregate  of  tens  of  mil- 
lions of  dollars.  The  schedules  of  the  bankrupts'  debts 
speak  for  themselves.  The  most  surprising  feature  of  the 
whole  situation  is  that  in  many  cases  the  most  cursory 
examination  of  the  bankrupt's  books  would  have  revealed 
to  the  trained  auditor  that  gross  fraud  was  being  prac- 
ticed. A  more  intimate  relationship  between  professional 
auditors  and  credit  managers  would  prove  to  the  latter 
that  the  auditor  can  be  of  inestimable  service  in  many 
ways. 

Character 

Last  but  not  least  is  the  element  of  character.  In 
miQdern  business  it  is  almost  concealed,  owing  to  the  im- 
possibiUty  of  continuing  the  personal  relations  between 
bankers  and  borrowers.  The  modern  borrower's  balance 
sheet  may  be  submitted  to  hundreds  of  bankers.  But  the 
author  would  not  like  to  see  the  audit  program  of  the 
auditor  or  credit  manager  omit  all  consideration  of 
character. 

The  banker  has  to  consider  primarily  the  present  abil- 
ity of  the  borrower  to  repay  the  loan,  but  further  than 
this  his  business  foresight  will  make  it  possible  for  the 
banker  to  size  up  his  man  and  determine  whether  there 
is  not  some  inherent  lack  of  character  in  him,  either 
moral  or  executive,  which  may  at  some  future  time  make 
the  risk  more  hazardous  than  if  he  were  entirely  normal. 

Some  unprincipled  business  men  pay  all  of  their  debts, 
but  many  are  found  in  the  bankruptcy  courts  being 
relieved  of  their  obligations,  and  subsequent  success  does 
not  incHne  them  to  pay  the  debts  thus  discharged. 

The  honest  man  may  fail  honestly,  but  if  he  can  he 


^QQ  AUDITING 

will  pay  in  time,  and  we  may  be  thankful  that  there  are 
many  such.  Therefore  let  the  auditor  and  the  credit 
manager  study  human  nature  and  analyze  the  conditions 
presented  to  them  not  only  from  the  financial  standpoint 
but  from  a  moral  point  of  view  as  well. 

(d)  Investigation  in  Patent  Litigation 

An  investigation  to  ascertain  profits  realized  in  the 
manufacture  of  patented  articles,  where  infringement  of 
patent  rights  is  claimed,  and  the  claim  is  sustained,  or 
when  an  examination  is  ordered  pending  a  decision,  pre- 
sents several  novel  features,  as  compared  with  an  ordinary 
statement  of  profits. 

It  is  not  intended  to  discuss  the  matter  from  a  legal 
point  of  view,  and  it  may  be  that  the  principles  hereinafter 
set  forth  might  not  be  upheld  by  the  courts  in  some  juris- 
dictions. It  is  the  author's  experience,  however,  that 
most  of  these  cases  are  settled  out  of  court  owing  to  the 
enormous  expenses  involved  in  the  taking  of  testimony 
before  masters,  who  are  usually  appointed  where  matters 
of  account  are  involved. 

The  following  procedure,  therefore,  may  be  taken  as 
the  result  of  actual  practice,  following  negotiations  which 
usually  involve  concessions  on  both  sides,  rather  than 
settled  rules  laid  down  in  judicial  decisions. 

General  Accounting  Principles  Do  Not  Govern 

The  preliminary  conferences  in  a  matter  of  this  sort 
naturally  bring  out  opinions  which  differ  radically.  The 
injured  party  will  claim  everything  that  can  be  imagined, 
and  the  defendant  will  produce  a  statement  which  shows 
that  the  manufacture  of 'the  infringing  article  has  been 
attended  with  ruinous  losses.  From  the  beginning  it  is 
a  question  of  gradually  drawing  the  lines  closer,  until  each 


INVESTIGATIONS  50T 

has  stripped  his  case  of  redundant  matters  and  the  issue 
is  joined. 

It  will  be  found  that  ordinary  accounting  principles 
do  not  form  the  basis  of  the  claim  nor  of  the  defense. 
The  following  are  exceptions  to  accepted  practice: 

There  would  seem  to  be  no  excuse  whatever  for  appor- 
tioning any  part  of  the  general  expenses  as  a  part  of  the 
cost  of  the  business.  The  infringers  would  have  had  these 
expenses  to  pay  in  any  event  in  order  to  carry  on  their 
legitimate  business. 

If  the  principal  business  of  the  defendants  consists  of 
manufacturing  or  dealing  in  infringing  articles,  then  it 
may  be  proper  to  include  a  certain  part  of  the  general 
expenses,  but  items  of  a  questionable  nature  should  not 
be  included. 

As  defendants  are  not  supposed  to  have  pushed  the 
5ale  of  the  article,  it  hardly  seems  proper  that  any  credit 
should  be  claimed  for  special  exhibitions. 

Where  the  same  kind  of  materials  are  legitimately  used 
in  the  manufacture  of  other  goods  handled  by  the  defend- 
ants, and  the  purchases  are  not  earmarked  at  the  time  for 
any  particular  department,  it  would  seem  improper  that 
credit  should  be  allowed  for  any  materials  not  clearly  iden- 
tified as  having  been  used  in  the  infringing  product. 

Based  on  similar  accountings,  the  defendants  are  not 
entitled  to  place  a  scrap  valuation  upon  materials  remain- 
ing on  hand  when  they  were  compelled  to  stop  the  sale  of 
the  article,  but  they  could  be  compelled  to  scrap  the  arti- 
cles on  hand  at  that  time,  and  would  not  be  entitled  to 
any  credit  whatever  for  the  entire  cost  of  the  manufacture 
of  said  stock. 

It  does  not  seem  conceivable  that  the  defendants 
would  be  permitted  to  make  a  profit  out  of  their  wrong- 
doing, and  this  would  be  the  result  if  general  expenses 


^Q2  AUDITING 

and  similar  items  were  included,  as  the  tendency  would 
be  to  reduce  the  expenses  of  conducting  their  legitimate 
business.  If  they  have  been  ordered  to  account  for  the 
profit  made  by  them  in  the  manufacture  and  sale  of  arti- 
cles, the  court  will  undoubtedly  hold  that  the  word 
''profit"  as  here  used  means  the  difiference  between  the 
proceeds  from  the  sale  of  an  article  and  the  prime  cost 
(that  is,  labor  and  material)  of  such  sales,  and  that  the 
cost  of  goods  on  hand  at  the  end  of  the  period  should 
not  be  treated  as  an  item  of  cost  for  which  credit  can  be 
claimed. 

The  courts,  however,  do  not  seem  to  accept  the  fore- 
going view.  In  the  case  of  Rubber  Company  v.  Goodyear, 
76  U.  S.  788,  where  a  master's  report  was  being  com- 
mented upon,  the  court  said  : 

He  refused  to  allow  manufacturer's  profits  and  interest  on  thp 
capital  stock.  This  was  correct.  The  profits  made  in  violation  of 
the  rights  of  the  complainants  in  this  class  of  cases,  within  the 
meaning  of  the  law,  are  to  be  computed  and  ascertained  by  finding 
the  difference  between  cost  and  yield.  In  estimating  the  cost,  the 
elements  of  price  of  materials,  interest,  expenses  of  manufacture 
and  sale,  and  other  necessary  expenditures,  if  there  be  any,  and  bad 
debts,  are  to  be  taken  into  account,  and  usually  nothing  else.  The 
calculation  is  to  be  made  as  a  manufacturer  calculates  the  profits 
of  his  business. 

In  Am  Ende  v.  Seabury,  43  Fed.  Rep.  672,  the  court 
said: 

The  master  properly  refused  to  allow  the  defendant,  as  an  ele- 
ment of  the  "factory  cost,"  ....  interest  on  the  capital  of  the 
corporation  invested  in  the  business. 

3.   FRAUD 

Following  the  discovery  of  an  embezzlement  may  be 
heard  expressions  of  surprise,  based  on  the  fact  that  the 
embezzler  was  a  trusted  employee.    It  does  not  seem  to 


INVESTIGATIONS  503 

occur  to  most  people  that,  generally  speaking,  no  one  but 
a  trusted  employee  has  an  opportunity  to  defraud  others. 
Many  trusted  employees  prove  recreant  to  their  trust 
every  year,  therefore  mere  business  prudence  demands 
some  form  of  supervision  over  all  those  who  have  a  chance 
to  appropriate  to  their  own  use  the  property  of  others. 

In  the  preceding  chapters  an  attempt  has  been  made 
to  outline  the  procedure  required  in  audits  of  various 
natures,  but  the  procedure  there  referred  to  was  not 
intended  to  cover  those  cases  where  a  particular  person 
is  under  suspicion  or  where  a  particular  form  of  fraud  is 
suspected,  or  has  been  discovered,  and  where  it  is  impor- 
tant to  locate  the  guilty  party  or  parties  without  delay. 

Then,  again,  it  may  be  that  an  audit  has  been  made 
along  usual  lines  without  developing  anything  wrong; 
but  it  is  found  that  an  employee  is  living  beyond  his 
means,  or  is  constantly  seen  in  bad  company,  so  that  a 
special  investigation  becomes  desirable.  The  point  imme- 
diately arises  as  to  whether  there  are  any  special  checks, 
or  verifications,  which  are  not  usually  resorted  to  in  an 
ordinary  audit,  but  which  might  be  useful  when  applied 
to  specific  cases. 

Possibilities  to  be  Studied 

In  all  cases  where  suspicion  exists  the  quickest  way 
to  locate  fraud  is  to  ascertain  definitely  the  opportunities 
which  are  normally  open  to  the  person  suspected,  and  the 
possible  chances  which  may  not  be  usually  open  to  such 
person,  but  of  which  he  may  have  taken  advantage. 

For  instance,  the  treasurer  of  a  company  may  be 
known  to  be  spending  more  tl^n  hi»  income,  and  an  inquiry 
is  ordered.  If  the  business  is  at  all  large,  it  is  obviously 
not  worth  while  to  commence  the  investigation  in  the 
same  way  as  a  general  audit,  but  the  wise  course  would 


-Q4  AUDITING 

be  to  look  into  the  matters  under  the  personal  charge  of 
that  officer.  Any  securities  supposed  to  be  in  his  hands 
should  be  called  for,  and  the  method  of  handling  cash 
transactions  should  be  inquired  into.  If  he  has  always 
insisted  on  opening  the  mail,  it  may  be  that  customers' 
accounts  have  been  tampered  with;  if  he  has  assumed  per- 
sonal charge  of  the  periodical  reconciliation  of  the  bank's 
pass-books  with  the  bank  balance,  it  may  be  that  funds 
have  been  withdrawn  from  the  bank  and  not  reported. 

If  the  gross  profit  is  unexpectedly  small,  it  may  be 
that  stock  is  being  stolen  or  that  fictitious  purchases 
appear  in  the  bocks. 

Extent  of  Fraud 

Frequently  the  professional  auditor  is  not  called  in 
until  the  embezzlement  has  been  disclosed  and  his  services 
are  desired  to  fix  the  total.  In  such  a  case  experience  is 
invaluable,  for  the  position  of  the  auditor  may  be  a  most 
difficult  one.  The  embezzler  usually  is  called  upon  to 
give,  or  profTers,  his  assistance,  and  professes  to  be  most 
anxious  to  help  get  at  the  whole  truth.  He  will  state 
the  total  amount  as  positively  not  exceeding  a  certain 
total,  and  his  employer  is  apt  to  believe  him  and  to  doubt 
the  auditor,  whose  experience  warrants  him  in  stating 
that  thieves  rarely  tell  the  truth,  and  that  embezzlers 
hardly  ever  know  the  extent  of  their  own  fraud,  and  when 
they  do  know  will  understate  it  materially  in  the  hope 
that  their  attempts  at  concealment  may  be  at  least  par- 
tially successful. 

There  is  only  one  safe  rule,  and  that  is  to  calculate 
every  possible  source  of  income  open  to  the  embezzler, 
the  maximum  amount  of  such  income,  and  the  longest 
time  possible  during  which  the  fraud  may  have  been 
ffoinsr  on. 


INVESTIGATIONS 


505 


Records  are  often  destroyed  and  many  sources  of 
income  cannot  be  traced  subsequently;  therefore  it  is 
never  wise  to  take  the  word  of  an  embezzler  for  the 
amount  of  his  theft. 

Attitude  Toward  an  Embezzler 

Whenever  possible  the  embezzler  should  be  required 
to  attend  and  assist  the  auditor.  This  does  not  mean 
that  his  word  is  to  be  taken  blindly  or  that  he  is  to  be 
left  alone  with  the  books,  but  he  can  do  no  harm,  and 
in  countless  cases  his  presence  has  been  of  the  greatest 
assistance. 

Here  the  experience  and  skill  of  the  auditor  have  full 
play.  By  the  exercise  of  tact  he  may  persuade  the  crimi- 
nal to  disclose  many  things  which  the  closest  examination 
of  the  records  would  not  reveal.  A  clue  is  often  as  valu- 
able as  a  complete  disclosure,  and  it  rarely  happens  that 
a  trained  auditor  spends  any  considerable  time  with  an 
embezzler  without  discovering  directly  or  incidentally  the 
system  employed  and  other  valuable  information. 

No  one  knows  so  well  as  professional  auditors  how 
small  a  proportion  of  these  crimes  are  made  public,  but 
embezzlers  themselves  seem  to  feel  intuitively  that  if  they 
promise  to  tell  all  they  know  and  to  make  restitution,  all 
will  be  forgiven  and  forgotten.  Unfortunately,  from  the 
standpoint  of  example  this  is  often  too  true,  but  even 
though  it  is  true  there  can  be  no  objection  to  an  auditor 
pointing  out  to  the  embezzler  the  fact  that  if  he  lies  to 
him  (the  auditor),  it  will  aggravate  his  possible  punish- 
ment. If  an  examination  is  Hkely  to  result  in  litigation, 
the  auditor  must  pay  particular  attention  to  any  admis- 
sions or  statements  by  the  suspected  party. 

The  chairman  of  a  board  of  water  commissioners  kept 
a    cash   book    showing    his    receipts    and    disbursements. 


5o6 


AUDITING 


When  the  balance  was  ascertained  by  auditors  appointed 
by  the  municipality,  the  chairman  was  informed  of  the 
amount  shown  by  the  book  to  be  due  from  him,  the  cor- 
rectness of  which  he  did  not  dispute.  On  being  asked  if 
he  could  explain  the  balance  against  him,  he  said  he  could 
not,  and  being  then  told  that  it  would  have  to  be  reported 
to  the  authorities,  he  replied:  "Well,  you  will  just  have 
to  report  it."  When  he  refused  to  pay  subsequently  and 
suit  was  brought,  the  court  held  that  this  was  sufficient 
evidence  upon  which  to  recover  the  balance. 

This  supports  the  principle  of  law  that  the  statement 
of  an  account  need  not  be  confined  to  the  original  parties. 
The  auditor  may  have  an  exceptional  chance  to  secure  an 
admission,  and  if  there  is  any  likelihood  of  its  being  used 
later,  he  should  reduce  it  to  writing  at  once.  This  record 
may  be  useful  in  refreshing  his  memory. 

Definitions 

Auditors  usually  work  for  or  with  lawyers  in  cases 
of  fraud,  and  it  is  well  for  them  to  understand  the  legal 
significance  of  terms  in  general  use. 

Fraud,  as  applied  to  accountancy  matters,  embraces 
all  dishonest  or  deceitful  acts  whereby  the  owner  of  prop- 
erty is  deprived  thereof  without  his  knowledge  or  consent. 
The  intention  to  deceive  is  a  characteristic  of  fraud,  but 
deceit  in  itself  does  not  reach  the  gravity  of  fraud. 

Embezzlement  is  the  fraudulent  appropriation  to 
one's  own  use  of  the  money  or  goods  intrusted  to  his 
care  by  another.  The  auditor  should  distinguish  embez- 
zlement from  larceny  or  theft,  because  in  the  case  of 
embezzlement  the  original  custody  or  receipt  of  the 
money  or  other  property  was  lawful,  or  with  the  consent 
of  the  owner,  while  in  larceny  the  felonious  intent  must 
have  existed  at  the  time  of  the  taking.    Therefore,  if  an 


INVESTIGATIONS  507 

ofificc  boy  were  to  take  and  retain  currency  out  of  a  cash, 
drawer,  he  would  be  guilty  of  larceny.  If  the  cashier  were 
to  take  and  retain  it,  he  would  be  guilty  of  embezzlement. 
In  other  words,  there  must  be  a  relation  of  special  trust 
in  regard  to  the  property  appropriated,  and  it  must  be  by 
virtue  of  such  employment  that  the  money  or  other  prop- 
erty comes  into  the  possession  of  a  person  to  make  it 
embezzlement  within  the  meaning  of  the  statutes. 

Misappropriation  is  not  a  technical  term  of  law,  but 
is  appHed  to  those  who  fraudulently  deal  with  money 
intrusted  to  them.  The  correct  term  for  such  an  act  is 
embezzlement. 

Defalcation  is  not  a  technical  term.  As  a  default 
usually  implies  that  property  appropriated  to  one's  own 
use  originally  came  into  his  possession  legally,  the  correct 
term  is  embezzlement. 


CHAPTER    XXI 

HOLDING    COMPANIES 

Consolidated  Balance  Sheets  and  Profit  and  Loss  State- 
ments 

In  the  face  of  the  Sherman  Act,  business  combinations 
are  being  formed  daily.  They  may  be  in  flagrant  or  in 
reasonable  restraint  of  trade,  or  they  may  deal  with  con- 
cerns operating  solely  within  the  boundaries  of  a  single 
state  and  thus  escape  Federal  prosecution  and  be  subject 
to  state  regulation  only  if  buying  or  selling  necessities. 

Politicians  and  friends  of  the  "plain  people"  may  cry 
aloud  that  competition  must  and  shall  be  preserved,  but 
the  real  fact  is  that  business  men  will  compete  up  to  a 
certain  point  only,  and  any  law  which  prohibits  competi- 
tors who  are  losing  money  from  coming  to  an  understand- 
ing or  consolidating  is  doomed  to  ultimate  failure. 
Auditors  will  therefore  be  called  upon  more  and  more  to 
investigate  proposed  consolidations  and  to  advise  with 
respect  to  their  accounts  after  mergers  have  been  efifected. 
It  is  not  intended  to  discuss  the  economic  features  of 
holding  companies.  Anyone  interested  in  this  phase  of 
the  subject  is  referred  to  the  paper  by  William  M.  Ly brand, 
C.P.A.,  which  appears  in  the  Year  Book  of  the  American 
Association  of  Public  Accountants  for  1908. 

Balance  Sheet 

The  usual  statement  of  assets  and  liabilities  published 
by  a  holding  company  is  wholly  devoid  of  the  information 

508 


HOLDING    COMPANIES 


509^ 


an  investor  or  stockholder  seeks.  On  one  side  appears  a 
huge  sum  opposite  the  caption,  "Securities  of  Subsidiary 
Companies."  Then  there  will  be  another  item  represent- 
ing advances  (usually  huge  also)  to  subsidiaries;  there 
may  be  a  little  cash,  but  other  assets  are  scarce. 

Nor  is  the  lack  of  information  found  in  connection 
with  the  so-called  ''trusts"  only.  There  are  a  great  many 
combinations  of  small  concerns,  and  with  these  the  failure 
to  render  intelligent  accounts  is  quite  as  marked  as  is  the 
case  with  larger  enterprises. 

The  chief  criticism  leveled  against  these  formal  state- 
ments is  that  in  the  absence  of  data  relative  to  the  quick 
assets  and  liabilities  of  the  subsidiaries,  no  opinion  can  be 
formed  as  to  whether  the  concern  as  a  whole  is  properly 
financed  or  whether  there  is  absolute  need  of  additional 
working  capital  to  prevent  bankruptcy. 

The  balance  sheets  of  some  holding  companies  show 
among  the  assets  the  net  assets  of  the  subsidiaries.  That 
is,  from  the  accounts  receivable  and  inventories  will  be 
deducted  the  accounts  payable,  the  resulting  balance 
being  shown  as  an  asset.  This  is  obviously  wrong.  The 
trade  debts  may  be  out  of  proportion  to  the  assets  and 
may  be  overdue  and  pressing.  ..^i^ 

Strong  pressure  is  sometimes  brought  to  bear  on  an 
auditor  to  induce  him  to  prepare  the  balance  sheet  of  a 
holding  company  so  that  it  will  indicate  a  stronger  finan- 
cial position  than  actually  exists.  The  best  answer  to 
such  a  request  is  a  positive  declaration  on  the  part  of 
the  auditor  that  proper  accounting  procedure  requires  a 
certain  form  of  balance  sheet  and  that  there  will  be  no 
deviation  therefrom. 

Form  of  Balance  Sheet 

As  just  stated,  the  form  of  the  balance  sheet  is  of 


Sio 


AUDITING 


great  importance.     Mr.  Lybrand,  in  the  paper  heretofore 
mentioned,  covers  this  point: 

It  is  now  very  generally  recognized,  however,  that  the  sub- 
mission of  the  balance  sheet  of  the  holding  company  only  does 
not  furnish  the  owners  of  the  company  with  the  information  as  to 
its  real  financiah  position  to  which  they  may  justly  consider  them- 
selves entitled. 

The  holding  company  was,  as  heretofore  stated,  organized  for 
the  purpose  of  acquiring  the  capital  stocks  of  affiliated  companies, 
and  thus  effecting  a  combination  which  would  bear  the  test  of 
adverse  legal  scrutiny.  While  each  company  under  this  scheme 
retains  its  corporate  identity,  and  is  in  the  eyes  of  the  law  a  sep- 
arate corporation,  yet  there  is  a  virtual  consolidation  of  ownership, 
the  results  of  which  can  be  properly  expressed  in  a  statement  of 
their  accounts  only  by  consolidating  the  balance  sheets  of  all  com- 
panies into  one  balance  sheet,  eliminating  therefrom  the  inter- 
company stocks,  bonds,  and  accounts  which  indicate  the  relation  of 
one  company  to  another  and  not  to  the  public. 

A  consolidated  balance  sheet,  therefore,  is  intended  to  reflect 
the  financial  position  of  the  whole  group  of  affiliated  companies, 
considered  as  one  undertaking.  In  a  typical  balance  sheet  of  this 
character,  the  following  grouping  and  arrangement  of  the  assets 
and  liabilities  has  been  adopted: 


Assets 

Liabilities 

Property  Account 

Capital  Stock  of  Holding  Cor- 

Deferred Charges  to  Operation 

poration 

Investments 

Capital     Stocks     of     Subsidiary 

Sinking  and  Reserve  Fund  As- 

Companies    Not     Owned    by 

sets 

Holding  Corporation 

Current  Assets 

Bonded  Indebtedness 

Current  Liabilities 

Sinking  and  Reserve  Funds 

Surplus 

When  a  holding  company  purchases  the  capital  stock  of  an- 
other company,  the  price  paid  for  this  capital  stock  presumably 
represents  the  holding  company's  estimate  of  the  value  of  the 
equity  in  the  subsidiary  company's  assets.  This  price  may  be 
greater  than  the  combined  capital  stock  and  surplus  account  of 
the  subsidiary  company,  in  which  event  the  difference  must  be 
assumed  to  denote  the  value  of  the  subsidiary  company's  good- 


HOLDING    COMPANIES  5II 

will,  or  other  assets,  not  appearing  on  its  balance  sheet,  otherwise, 
if  they  were  included  there,  the  cost  of  the  capital  stock  to  the 
holding  company  would  be  exactly  equal  to  the  combined  capital 
and  surplus  of  the  subsidiary  company.  On  the  other  hand,  if  the 
price  paid  by  the  holding  company,  for  the  capital  stock  of  the  sub- 
sidiary company,  is  less  than  the  combined  capital  and  surplus,  the 
difference  must  be  assumed  to  express  the  amount  at  which  the 
assets  of  the  subsidiary  company  are  overvalued  on  its  books. 

In  consolidating  the  "Property"  accounts  of  the  subsidiary 
companies  (their  property  accounts  including  good-will,  trade- 
marks, franchises,  etc.,  as  well  as  tangible  property)  the  total 
must,  therefore,  be  increased  or  reduced  by  as  much  as  the  cost  of 
the  capital  stocks  of  the  respective  subsidiary  companies,  as  at  the 
date  of  their  purchase  by  the  holding  company  exceeds  or  falls 
below. their  combined  capital  and  surplus  account. 

It  might  seem  at  first  thought  that  the  surplus  accounts  of  the 
subsidiary  companies  should  not  be  applied  as  stated  in  the  fore- 
going paragraph,  but  that  they,  together  with  the  surplus  accrued 
subsequent  to  the  purchase  by  the  holding  comi:^any,  should  be 
combined  and  their  aggregate  entered  on  the  consolidated  balance 
sheet  as  the  surplus  of  the  whole  undertaking.  The  fallacy  of  this 
statement  has  been  proven  in  various  ways.  Perhaps  the  most 
simple  and  direct  argument  is  somewhat  along  the  following  lines: 
the  surplus  of  ^  corporation,  generally  speaking,  represents  the 
balance  of  earnings  which  have  accumulated  from  its  operations, 
and  which  have  not  been  paid  out  to  the  stockholders,  applied  in 
immediate  reduction  of  valuation  of  assets  or  reserved  for  the  ulti- 
mate replacement  thereof.  As  a  surplus  can  accrue  only  during 
the  operating  of  a  company,  it  is  fairly  obvious  that  the  holding 
corporation  prior  to  its  organization  cannot  have  earned  such  a 
fund,  and  that  therefore  it  would  be  entitled  to  merge  into  its  con- 
solidated surplus  account  only  the  balance  of  profits  accumulated 
by  the  subsidiary  companies  during  the  period  of  their  ownership 
by  the  holding  corporation. 

Further,  as  the  amount  paid  by  the  holding  company  for  the 
capital  stock  of  a  subsidiary  company  represents  the  holding  com- 
pany's estimate  of  the  equity  in  the  subsidiary  company,  and  as 
that  equity  is  presumed  to  be  represented  by  its  capital  stock  and 
surplus  account,  it  follows  that  in  the  process  of  consolidating,  the 
capital  stocks  of  the  subsidiary  company  in  the  holding  company's 
books  will  be  eliminated,  as  will  be  the  capital  stock  and  surplus 
account  on  the  subsidiary  company's  books.  The  surplus  account 
being  thus  absorbed,  cannot,  of  course,  appear  again  as  a  surplus  in 
the  consolidated  balance  sheet.  - 


512 


AUDITING 


It  will  be  noted  from  the  foregoing  that  all  intercom- 
pany accounts  are  eliminated,  thus  exhibiting  the  debts 
due  from  the  public  and  to  the  public.  Any  other  form 
of  balance  sheet  which  includes  as  assets  accounts  due  by 
one  company  to  another,  and  as  liabilities  accounts  due 
from  one  company  to  another,  is  misleading  and  useless  for 
the  purpose  of  disclosing  what  will  be  realized  from  the 
quick  assets  and  the  amounts  which  will  have  to  be  paid. 

Some  question  may  arise  as  to  the  treatment  of  bonds 
of  a  subsidiary  not  guaranteed  by  the  holding  company. 
Where  the  assets  of  the  subsidiary  are  sufficient  to  cover 
this  liability  the  point  is  an  academic  one,  but  instances 
may  be  found  where  the  bonds  of  a  subsidiary  are  not  fully 
secured.  The  consolidation  of  the  balance  sheet  of  one 
with  the  other  would  thrust  upon  the  holding  company 
a  liability  not  directly  assumed,  and  if  the  auditor  were 
sure  that  no  contingent  liability  existed  in  respect 
thereof,  he  might  sanction  the  omission  of  both  the  assets 
and  liabilities  of  the  subsidiary.  As  mentioned  hereafter, 
however,  it  will  usually  be  found  that  the  holding  com- 
pany will  assume  such  a  liability  for  the  sake  of  continuing 
the  business,  in  which  case  the  full  amount  of  the  bonds 
must  be  carried  as  a  liability. 

It  is  obvious  that  the  capital  stock  of  the  subsidiary, 
all  or  partly  owned  by  the  holding  company,  is  of  no  value 
unless  the  depreciation  in  the  value  of  the  assets  is  abnor- 
mal, and  there  is  a  reasonable  assurance  that  the  deficit 
will  be  more  than  made  good  out  of  future  earnings. 

Accounts  Receivable  ^ 

Where  advances  have  been  made  to  subsidiary  com- 
panies by  the  holding  company  itself,  the  aggregate 
thereof  will  appear  among  the  assets  of  the  holding  com- 
pany, but  the  auditor  should  never  permit  the  item  to  be 


HOLDING    COMPANIES  513 

Stated  in  such  a  manner  as  to  sustain  a  belief  on  the  part 
of  any  outsider  that  the  receivables  are  due  from  debtors 
other  than  subsidiary  companies. 

Quoting  again  from  Mr.  Lybrand: 

Frequently  other  large  items  of  assets  are  advances  made  to 
the  subsidiary  companies  for  which  the  latter  may  have  issued  their 
notes  in  favor  of  the  parent  company.  Such  advances  are  usually 
made  to  provide  for  extensions  or  additions  to  the  plants  of  the 
subsidiary  companies  after  they  have  been  acquired  by  the  holding 
company,  or  they  may  have  been  made  for  the  purpose  of  furnish- 
ing additional  funds  to  purchase  larger  stocks  of  materials,  to  carry 
contracts  requiring  considerable  time  to  complete,  or  for  any  other 
legitimate  business  purpose.  If  the  moneys  advanced  have  been  for 
the  purpose  of  adding  to  the  plants  of  the  subsidiary  companies,  it 
may  be  that  these  loans  will  subsequently  be  funded  by  the  sub- 
sidiary companies  through  the  medium  of  mortgage  bonds,  which, 
if  sold  to  the  public,  will  enable  the  subsidiary  companies  to  dis- 
charge their  debts  to  the  parent  company.  Or  possibly,  if  the 
whole  of  the  authorized  stock  of  the  subsidiary  compar^y  is  not 
outstanding,  a  further  amount  may  be  issued  and  delivered  to  the 
parent  company  in  settlement  of  the  advances,  thus  changing  the 
form  of  the  asset  on  the  holding  company's  books  from  an  account 
receivable  to  a  security  ownership.  It  is  improbable  that  such  a 
course  would  be  pursued  except  in  very  special  instances,  as  the 
holding  company  would  doubtless  prefer  to  appear  as  a  creditor 
of  the  subsidiary  company  rather  than  as  an  owner  of  more  shares 
of  its  capital  stock,  because,  if  the  subsidiary  company  were  un- 
profitable and  it  became  necessary  to  wind  it  up,  the  holding  com- 
pany would  claim,  with  the  other  creditors,  its  proportion  of  the 
realizations  from  the  subsidiary  company's  assets.  Such  a  position, 
we  believe,  would  be  assumed  by  the  holding  company  in  the  ab- 
sence of  direct  ruling  to  the  contrary,  but  serious  doubt  has  been 
cast  recently  on  the  ability  of  a  holding  company  to  sustain  such  a 
contention  where  it  is  the  owner  of  the  entire  capital  stock  issue  of 
the  underlying  company. 

Advances  made  by  a  parent  company  to  its  subsidiary  com- 
panies are  not  always  represented  in  the  latter  by  tangible  prop- 
erty. Such  advances  may  have  been  made  to  recoup  the  subsidiary 
company  for  losses  sustained  by  it  in  operating.  The  advances 
appearing  on  the  books  of  the  parent  company-  would,  under  such 
conditions,  be  nominal  assets  only,  and  as  such  in  a  balance  sheet 
of  the  holding  company  they  should  be  offset  by  a  reserve  sufficient 


^I^  AUDITING 

to  provide  for  the  whole  or  such  part  of  them  as  may  be  repre- 
sented by  losses. 


Profit  and  Loss  Account 

Certain  holding  companies  continue  to  show  as  gross 
earnings  only  such  dividends  as  have  been  received  during 
the  period  from  the  subsidiary  companies.  Such  practice 
merits  the  strongest  censure.  The  author  has  heard  it 
contended  that  inasmuch  as  the  only  legal  method  which 
a  corporation  has  of  distributing  profits  is  by  means  of 
dividends,  it  would  be  most  improper  for  a  holding  com- 
pany to  take  credit  for  part  or  all  of  the  earnings  of  a 
subsidiary  company  which  had  not  been  so  distributed. 
This  sounds  well  in  theory,  but  in  practice  it  is  the  argu- 
ment of  dishonest  men.  Almost  invariably  the  sole  reason 
for  taking  advantage  of  this  technicality  is  that  one  or 
more  of  the  subsidiaries  have  incurred  a  net  loss  in  excess 
of  the  aggregate  profits  of  all  of  the  companies,  and  the 
management  of  the  holding  company,  wishing  to  conceal 
such  loss,  seeks  by  subterfuge  to  justify  the  action. 

An  auditor  cannot  be  too  positive  on  this  point. 
Wherever  a  holding  company  owns  and  controls  one  or 
more  subsidiaries,  the  profits  or  losses  of  the  subsidiaries 
must  be  stated  for  the  same  period  as  that  of  the  holding 
company  and  consolidated.  Any  other  method  may  lead 
to  gross  abuse. 

The  directors  of  a  holding  company,  the  sole  income 
of  which  was  the  dividends  of  subsidiaries,  could  withhold 
dividends  from  prosperous  companies  while  they  were 
accumulating  the  stock  of  the  holding  company,  and 
would  be  lavish  with  such  dividends  whenever  they  desired 
to  sell  their  holding  company  stock.  This  is  not  mere 
supposition  on  the  part  of  the  author.  Holding  company 
profit  and  loss  accounts  are  made  up  in  the  manner  indi- 


HOLDING    COMPANIES  515 

cated,  and  inexperienced  professional  auditors  are  some- 
times induced  to  certify  to  their  accuracy,  being  misled 
by  the  apparent  legality  of  the  procedure. 

As  experienced  and  reputable  auditors  invariably  de- 
cline to  permit  their  names  to  be  connected  with  a  form 
of  statement  which  is  dishonest  in  fact  if  not  in  theory, 
this  caution  as  to  the  profit  and  loss  account  of  holding 
companies  should  be  taken  advantage  of  by  an  auditor 
who  may  have  the  matter  presented  to  him  for  the  first 
time. 

Ernest  Reckitt,  C.P.A.,  relates  the  following  incident: 

I  have  in  mind  a  case  where  I  was  called  in  to  make,  as  I  sup- 
posed, an  audit  of  the  books  not  only  of  the  "Holding  Company," 
but  also  of  the  subsidiary  companies,  and  was  amazed  to  find  that 
it  was  proposed  to  have  me  audit  only  the  "Holding  Company's" 
books.  Upon  explaining  that  I  could  give  no  certificate  on  such 
audit,  the  most  specious  arguments  were  advanced  and  the  presi- 
dent of  the  company  attempted  to  use  the  full  force  of  his  strong 
personality  to  persuade  me  to  defer  to  his  wishes,  which  naturally 
only  made  me  suspect  still  more  the  motives  which  actuated  him. 
Finally,  and  with  great  reluctance,  they  handed  me  the  books  of 
the  subsidiary  companies,  and  I  found  out  that  two  of  the  com- 
panies had  made  losses  aggregating  over  $200,000,  no  part  of  which 
losses  had  been  taken  care  of  on  the  books  of  the  "Holding  Com- 
pany," though  they  had  been  careful  to  bring  on  to  the  books  of 
the  "Holding  Company"  the  profits  made  by  other  subsidiary  com- 
panies. One  year  later,  the  "Holding  Company"  and  most  of  the 
subsidiary  companies  were  in  bankruptcy,  as  they  deserved  to  be. 

The  author  was  called  upon  several  years  ago  to  audit 
the  accounts  of  a  holding  company  in  a  large  Southern 
city,  and  of  all  of  its  subsidiaries.  The  latter  included 
enterprises  of  different  kinds,  but  as  the  holding  company 
owned  practically  all  of  the  stock  of  each  underlying 
company,  it  was  necessafry  to  consolidate  the  operations 
of  the  entire  group  in  order  to  show  its  exact  net  earnings. 
Unfortunately,  several  of  the  concerns  were  not  profitable, 


5i6 


AUDITING 


and  the  consolidated  profit  and  loss  account  was  not  a 
document  to  be  proud  of. 

One  of  the  subsidiaries,  however,  was  quite  prosperous, 
and  its  net  earnings  in  themselves  were  sufficient  to  pay 
interest  and  dividends  on  the  holding  company's  bonded 
debt  and  capital  stock,  but  the  losses  of  the  other  com- 
panies seriously  depleted  the  funds  of  the  holding  com- 
pany and  rendered  dividends  impossible. 

A  short  time  afterwards,  the  president  of  the  company 
appeared  in  New  York  with  a  large  block  of  the  holding 
company's  bonds  for  sale.  He  submitted  to  the  bankers, 
not  the  auditor's  report,  but  a  statement  showing  the 
earnings  of  the  profitable  subsidiary  and  ignoring  so  far 
as  possible  the  existence  of  the  other  companies,  and  the 
bonds  sold  readily. 

Quoting  Mr.  Lybrand  on  the  matter  of  the  prepara- 
tion of  the  profit  and  loss  account: 

!  Most  of  the  comment  that  Is  applicable  to  the  consolidated 

balance  sheet  is  pertinent  to  the  consolidated  profit  and  lo/ss  ac- 
count. In  the  consolidated  profit  and  loss  account  transfer  of 
profits  from  subsidiary  companies  to  the  holding  company  through 
the  medium  of  dividends  will  be  ignored,  and  the  earnings,  ex- 
penses, and  charges  of  the  several  companies  will  be  combined  and 
stated  as  though  the  corporation  were  one  enterprise. 

In  the  consolidated  statement,  therefore,  will  appear  the  entire 
gross  earnings  of  the  group  of  affiliated  companies.  Such  gross  earn- 
ings will  represent  cumulatively  the  operations  of  the  several  un- 
derlying companies,  i.e.,  merchandise  transformed  into  a  market- 
able condition  by  one  company  and  transferred  to  a  second  com- 
pany for  further  manipulation  and  sale  in  a  different  form  would 
appear  in  the  gross  earnings  of  each  company  and  their  aggregate 
in  the  consolidated  profit  and  loss  account.  While  on  the  surface 
it  would  seem  that  there  is  a  duplication  of  gross  earnings  under 
this  method,  it  is  probably  the  only  practical  way  in  which  to  state 
them  where  there  is  a  large  number  of.  companies  with  very  many 
manufacturing  processes. 

Again,  as  the  property  account  of  the  various  subsidiary  com- 
panies are  consolidated  in  the  balance  sheet,  it  would  seem  that 


HOLDING    COMPANIES  517 

the  gross  operations  of  those  companies  should  likewise  be  aggre- 
gated in  order  to  show  the  relation  of  the  volume  of  business  to 
the  property  investment. 

From  such  gross  earnings  will  be  deducted  the  entire  operating 
costs  incurred  in  producing  those  earnings,  the  balance  resulting 
being  then  subject  to  the  addition  of  income  of  a  miscellaneous 
nature,  and  the  deduction  of  expenses  which  are  not  applicable 
directly  to  the  manufacturing  and  producing  operations. 

In  stating  the  consolidated  income  and  profit  and  loss  ac- 
count there  will  probably  be  some  difference  of  opinion  as  to  the 
point  at  which  charges  other  than  for  ordinary  operating  should 
rest,  in  order  that  the  current  net  earnings  of  the  undertaking  may 
be  shown. 

It  is  fairly  clear  that  from  the  gross  earnings  must  first  be 
deducted  the  costs  in  labor,  materials,  and  operating  expenses  in- 
curred in  producing  those  earnings,  in  order  that  a — let  us  call  it 
manufacturing — profit  may  be  shown.  It  is  true  that  in  an  indus- 
trial enterprise,  which  includes  mining,  land  and  water  transporta- 
tion, as  well  as  many  forms  of  manufacturing,  such  an  expression 
is  in  a  sense  a  misnomer,  but  as  the  mining  and  transportation  are 
really  tributary  to  the  manufacturing,  the  title  might  stand.  It  is 
true  also  that  there  are  so  many  different  kinds  of  products,  with 
varying  rates  of  profits  included  in  the  gross  earnings  that  com- 
paratively little  use  can  be  made  of  the  figures  as  a  basis  of  com- 
parison from  year  to  year.  Nevertheless,  as  it  is  impossible  in  a  con- 
densed statement  to  show  the  volume  and  profit  of  each  Hne  of 
business,  the  aggregate  figures  will  give  the  stockholder  some  in- 
formation as  to  the  total  business,  and,  in  a  rough  way,  the  rate  of 
profit  thereon  for  comparison  with  preceding  periods. 

From  the  gross  profit  so  ascertained  would  be  deducted  the  ad- 
ministrative, selling,  and  general  expenses,  virtually  common  to 
the  whole  enterprise,  and  chargeable  against  the  operations  as  a 
whole.  The  resulting  balance  will  be  subject  to  adjustments  be- 
cause of  extraordinary  items  relating  to  operating,  but  which  can- 
not be  included  fairly  in  the  current  operating  costs;  and  by  income 
from  investments  other  than  those  representing  the  holding  com- 
pany's ownership  of  the  subsidiary  companies. 

The  balance  then  carried  forward  from  the  current  profit  and 
loss  to  the  income  or  general  profit  and  loss  account  will  be  re- 
duced by  reason  of  reserves  for  depreciation,  replacement,  sinking 
fund  requirements,  etc.,  which  are  properly  appropriated  out  of 
current  earnings.  Logically,  such  items  should  be  deducted  before 
the  balance  of  current  profits  is  struck,  because  the  depreciation 
^nd  replacement  reserve  at  least  are  charges  directly  connected 


5i8 


AUDITING 


with  operating,  but  as  heretofore  remarked,  depreciation  statistics 
are  not  sufficiently  accurate,  and  the  practice  of  reserving  for 
depreciation  is  not  yet  common  enough  to  justify  the  inclusion  of 
such  charges  with  the  ordinary  operating  costs.  Further,  if  they 
are  stated  separately,  attention  is  drawn  to  the  fact  that  reserve 
for  depreciation  has  been  made  and  to  the  amount  of  that  provision. 

The  balance  of  profits,  after  deducting  the  foregoing  reserves, 
shows  the  position  of  the  earnings  with  respect  to  the  interest  pay- 
able on  the  debt  of  the  subsidiary  and  holding  companies.  It  may 
be  held  that  interest  on  bonds  of  subsidiary  companies  (being  a 
lien  which  must  be  deducted  by  the  subsidiary  company  from  its 
earnings  before  it  can  appropriate  the  remainder  to  the  holding 
company)  should  be  applied  before  the  balance  of  current  earnings 
fs  shown.  It  is  suggested,  however,  that  it  is  preferable  to  embrace 
all  of  the  interest  on  the  funded  debt  of  the  companies  in  one- 
group,  in  order  that  the  total  thereof  may  appear;  also  because 
the  bonded  debt  of  the  subsidiary  companies  may  change  by  reason 
of  new  securities  of  the  holding  company  being  issued  in  lieu 
thereof,  or  it  may  be  reduced  through  the  operation  of  the  sinking 
funds,  in  either  of  which  events  the  interest  charge  would  be  les- 
sened and  a  comparison  of  operating  profits  from  year  to  year  dis- 
turbed. 

After  the  deduction  of  interest  on  the  bonded  debt,  the  balance 
remaining  represents  the  profits  available  for  dividends. 

Partial  Ownership  of  Subsidiaries 

The  foregoing  remarks  apply  where  the  holding  com- 
pany owns  all  of  the  stock  of  the  subsidiary  companies,  but 
in  those  cases  where  the  holding  company  owns  part  only 
of  the  stock,  some  adjustment  of  the  consolidated  profit 
and  loss  account  may  be  necessary. 

Where  a  profit  is  shown,  the  amount  to  be  included  as 
the  share  of  the  holding  company  is  the  proportion  the 
stock  owned  by  the  Irolding  company  bears  to  the  total 
capital  outstanding.  It  must  be  assumed  that  the  minority 
stockholders  will  eventually  receive  through  dividends 
their  share  of  the  profits. 

Where  a  loss  is  shown,  and  where  losses  form  the 
chronic  condition  of  the  subsidiary,  it  may  as  well  be  rec- 
ognized that  the  holding  company  will  have  to  assume  all 


HOLDING    COMPANIES 


519 


of  it.  This,  of  course,  applies  only  to  those  cases  where  a 
subsidiary  company  is  so  largely  owned  by  the  holding 
company  that  the  minority  interest  cannot  be  depended 
upon  to  advance  its  share  of  the  funds  necessary  to  take 
care  of  the  loss. 

The  holding  company  may  carry  these  advances  as  an 
asset,  but  the  auditor  will  place  such  a  value  upon  these 
items  as  the  facts  warrant,  and  it  is  reasonably  certain  that 
the  final  result  will  be  to  include  all  of  the  loss  in  the  con- 
solidated profit  and  loss  account,  although  something  less 
than  100  per  cent  of  the  stock  of  the  subsidiary  is  owned. 

Comparative  Statements 

Where  the  accounts  of  several  subsidiaries,  operating 
along  substantially  the  same  lines,  are  examined,  one  very 
important  object  is  to  endeavor  so  to  state  the  accounts 
that  the  results  are  reduced  to  a  uniform  basis.  Many  ad- 
justments may  be  necessary  to  take  care  of  local  condi- 
tions, etc.,  but  no  form  of  presentation  is  clearer  or  more 
valuable. 

Where  comparative  costs  are  feasible,  it  is  important 
to  ascertain  the  amount  of  the  plant  investment,  as  it  may 
be  that  the  costs  as  reported  do  not  include  depreciation 
nor  interest.  The  latter  is  usually  omitted  from  costs  on 
the  ground  that  it  is  a  profit  on  capital  employed  and 
therefore  cannot  be  an  element  of  cost.  Admitting  this, 
"without  prejudice,"  it  might  nevertheless  serve  to  con- 
ceal actual  lack  of  ability  on  the  part  of  the  manager  of 
one  factory  as  compared  with  another.  One  might  keep 
twice  as  much  capital  tied  up  in  raw  materials  and  goods 
in  process  as  the  other,  and  where  units  of  costs  are  stated 
in  fractions  of  a  cent,  the  interest  on  the  excessive  capital 
employed  might  be  sufficient  to  prove  the  superiority  of 
one  manager  over  another. 


CHAPTER    XXII 

INTEREST 

The  professional  auditor  should  be  thoroughly  ac- 
quainted with  the  various  methods  of  calculating  interest. 
There  is  a  remarkable  lack  of  uniformity  among  business 
houses,  and  even  banks,  on  the  subject.  The  audit  clerk 
who  verifies  interest  collections  or  interest  payments  feels 
relieved  if  his  own  calculation  agrees  within  a  few  dollars 
with  the  amount  received  or  paid  and  lets  it  go  at  that. 

As  the  ''few  dollars"  multiplied  a  number  of  times  will 
aggregate  a  considerable  sum,  it  is  important  that  the 
auditor  familiarize  himself  with,  and  require  his  clerks  to 
learn,  the  laws  and  customs  governing  interest,  so  that 
when  a  test  is  made  it  will  be  done  intelligently,  and  if  the 
amount  received  is  insufficient  or  the  amount  paid  is  ex- 
cessive, a  report  may  be  made  thereon  with  confidence  in 
the  correctness  of  the  criticism. 

The  three  factors  entering  into  the  calculation  of  in- 
terest are  principal,  rate,  and  time. 

Principal 

Principal  is  the  amount  on  which  interest  is  to  be  cal- 
culated. There  are  two  methods  of  reckoning  principal. 
In  bank  discount  the  principal  is  regarded  as  the  entire 
face  of  the  note.  For  example,  the  bank  discount  on  a 
note  for  $1,000  payable  at  one  year  at  6  per  cent  would  be 
$60,  and  the  proceeds  paid  to  the  customer  would  be  $940. 
It  will  be  noted  that  here  the  customer  has  the  use  of  only 

520 


INTEREST  521 

$940  for  one  year,  and  yet  he  pays  interest  for  the  use  of 
$1,000  for  one  year.  The  actual  principal  on  which  in- 
terest should  be  chargeable  is  only  $940.  The  fictitious 
principal,  on  which  interest  actually  is  charged,  is  $1,000. 
The  true  principal  in  such  case  is  found  by  the  following 
proposition: 

1.06   :  1.00   ::  $1,000   :  X 
which  gives  a  present  value  of  $943.40  for  X 

In  spite  of  the  foregoing  facts,  it  is  now  thoroughly 
well  settled  by  universal  usage  that  this  system  of  bank 
discount  will  be  permitted  by  the  courts,  even  though  it 
does  actually  effectuate  usury. 

The  right  is  expressly  given  to  national  banks  by 
U.  S.  Rev.  Stats.,  Sec.  5197,  now  Sec.  5197  of  the  U.  S. 
Compiled  Statutes. 

The  right  is  also  given  to  New  York  banks  by  Section 
74  of  the  Banking  Law  of  that  state. 

But  the  practice  of  anticipating  the  interest  in  this 
fashion  has  been  held  not  to  authorize  the  charging  of  in- 
terest on  the  anticipated  interest  in  case  such  interest  is 
not  paid  at  the  date  of  the  execution  of  the  note. 

In  the  case  of  First  National  Bank  v.  Davis,  108  111. 
633  (Sup.  Ct.  111.,  1884),  a  note  was  given  for  $8,000  at 
one  year  at  10  per  cent.  It  was  renewed  at  maturity.  The 
renewal  note,  instead  of  being  for  $8,800,  was  for  $8,880, 
made  up  as  follows:  $8,000  principal,  $800  anticipated  in- 
terest, and,  as  the  bank  did  not  receive  the  $800  antici- 
pated interest  on  the  date  of  execution  of  the  renewal,  but 
merely  took  the  debtor's  promise  to  pay  the  $800  at  one 
year,  the  bank  added  10  per  cent  of  this  $800  (or  $80)  to 
the  face  of  the  renewal  note,  making  it  total  $8,880,  as 
stated.     The  court  held  this  to  be  usury. 


522  AUDITING 

The  question  of  principal  also  occurs  where  payments 
are  made  on  an  old  account  which  is  drawing  interest. 
Under  3uch  circumstances  the  debtor  sometimes  claims 
that  all  payments  should  apply  on  account  of  principal; 
but  unless  there  is  a  clear  and  specific  agreement  that 
they  shall  be  so  applied,  the  rule  is  well  settled  that  such 
payments  are  applicable  in  the  first  instance  to  all  arrears 
of  interest  before  any  application  can  be  made  on  account 
of  principal. 

The  question  of  principal  is  also  involved  in  cases 
dealing  with  compound  interest.  It  has  been  held  that 
interest  may  be  added  to  and  become  a  part  of  principal  at 
stated  times  and  under  certain  conditions,  and  the  ques- 
tion of  whether  or  not  this  is  permissible  will  sometimes 
determine  whether  or  not  the  transaction  is  usurious  or 
otherwise.  This  is  a  point  upon  which  an  auditor  is  fre- 
quently required  to  pass. 

Loan  accounts  and  book  accounts  between  interre- 
lated enterprises  sometimes  run  along  for  years  without 
a  final  settlement.  When  a  statement  is  desired  upon 
which  a  settlement  may  be  based,  there  is  always  a  temp- 
tation to  state  the  transactions  in  as  short  rests  or  periods 
as  possible,  the  interest  being  calculated  and  included  in 
each  balance  carried  forward.  This  results  in  compounding 
the  interest,  is  illegal,  and  should  never  be  permitted  by 
the  auditor. 

It  may  be  a  hardship  to  the  lender,  as  compound  in- 
terest would  be  legal  and  proper  in  such  a  case  if  the 
accounts  had  been  written  up  properly  at  the  time,  interest 
actually  entered  in  the  books,  and  statements  prepared 
therefrom  and  submitted  to  the  borrower  or  debtor.  If 
not  objected  to  at  the  time  nor  within  a  reasonable  time 
thereafter,  the  transaction  would  have  the  legal  efTect  of 
an  account  stated,  and  each  new  starting  balance,  although 


INTEREST 


523 


including  interest  calculated  at  shorter  intervals  than  a 
year,  being  acquiesced  in,  would  be  binding. 

In  the  absence  of  special  custom  or  agreement,  how- 
ever, interest  should  not  be  compounded. 

Rate  of  Interest 

This  rarely  or  never  admits  of  dispute  except  in  those 
cases  where  a  note,  contract,  bond,  or  other  obligation  is 
made  in  one  jurisdiction,  to  be  paid  or  performed  in  an- 
other jurisdiction  without  specifying  the  rate  of  interest, 
and  the  legal  rate  of  interest  in  the  two  jurisdictions  is 
difl'erent.  Then  the  question  sometimes  arises  whether 
the  rate  at  the  place  of  making  the  note  or  the  rate  at  the 
place  of  payment  is  to  govern. 

A  similar  question  arises  where  one  rate  of  interest  is 
the  legal  rate  at  the  time  of  making  the  note,  contract,  or 
bond,  and  another  legal  rate  is  in  force  when  the  obliga- 
tion falls  due. 

In  the  absence  of  an  intention  to  the  contrary  shown 
by  express  stipulation  or  otherwise,  the  rate  of  interest  is 
to  be  regulated  by  the  law  as  it  existed  at  the  time  and 
place  of  making  the  contract,  and  not  by  the  law  existing 
when  the  debt  falls  due  or  when  the  remedy  is  sought. 
(8  Cyc.  310.) 

It  is  well  settled,  however,  that  the  parties  may  con- 
tract for  the  legal  rate  in  either  place  and  the  contract 
will  govern. 

Time 

The  time  which  interest  is  to  run  gives  rise  to  a  wide 
diversity  of  practice. 

There  is  an  underlying  principle  which  is  of  very  gen- 
eral, although  not  absolutely  universal,  application,  and  it 
is  this,  that  if  the  first  day  of  the  interest  period  is  in- 


^24  AUDITING 

eluded  in  the  computation,  then  the  last  day  shall  be  ex- 
cluded; and  if  the  first  day  is  excluded,  then  the  last  day 
is  included.  The  parties  can,  if  they  will,  contract  other- 
wise.    (See  Blanchard  v.  Hilliard,  11  Mass.  85. 

Custom  in  Banks  and  Trust  Companies 

In  Kirkbride  &  Sterrett's  "The  Modern  Trust  Com- 
pany" (page  84),  the  rule  is  stated  to  be:  'Tn  computing 
interest  on  loans,  the  actual  number  of  days  is  taken.  If 
the  day  on  which  the  loan  was  made  is  included,  the  day 
of  payment  is  not  counted." 

It  is  more  or  less  common,  however,  for  banks  to  count 
both  the  first  and  last  days  when  the  interest  is  payable 
to  themselves.  This  custom  will  not  override  the  common 
law  rule  unless  the  parties  expressly  agree  to  it.  The  bank 
that  figures  time  thus  at  the  full  legal  rate  of  interest  in 
the  state  of  Vermont  is  guilty  of  usury,  but  not  corrupt 
usury.  Bank  of  Burlington  v.  Durkee,  1  Vt.  399.  The 
bank  that  does  this  same  thing  in  the  state  of  Virginia  is 
not  guilty  of  usury  at  all.  Crump  v.  Trytitle,  5  Leigh  251 
(Court  of  Appeals  of  Virginia,  1834). 

In  the  Crump  case,  last  cited,  the  court  even  held  that 
it  was  proper  for  the  bank  to  charge  interest  not  only  on 
the  first  and  last  day  of  the  original  note,  but  also  on  the 
first  and  last  day  of  successive  renewal  notes,  the  result 
being  that  the  bank  received  double  interest  on  every  day 
that  a  renewal  was  executed.  Many  banks  follow  that 
custom,  although  some  banks  are  content  with  charging 
the  first  and  last  day  on  the  original  note,  and  not  on  the 
renewal  note. 

The  legal  fiction  of  the  common  law  was  that  a  day  is 
indivisible,  and  therefore  even  if  a  customer  received  his 
discount  money  just  before  closing  on  the  date  of  his  note, 
and  paid  it  immediately  after  opening  on  the  date  of  ma- 


INTEREST  525 

turity,  he  would  still,  in  strict  contemplation  of  law,  have 
had  the  use  of  that  money  all  of  both  the  terminal  days, 
and  on  that  fiction  the  decision  in  the  Crump  case  was 
undoubtedly  sound  law.  Whether  it  was  equitable  or  not 
is  another  question. 

Where  banks,  however,  have  to  pay  interest,  instead  of 
receive  it,  they  apply  a  widely  different  rule. 

First.  They  quite  generally  credit  interest  on  deposits 
only  the  day  after  deposit,  on  the  theory  that  most  de- 
posits are  made  by  cheque  and  it  takes  one  day  on  an 
average  to  collect  through  the  clearing  house. 

Second.  Some  banks  provide  that  deposits  made  be- 
tween the  second  and  the  fifteenth  of  the  month  shall 
draw  interest  from  the  fifteenth;  and  that  deposits  made 
between  the  sixteenth  and  the  first  of  the  following  month 
shall  draw  interest  from  the  latter  date. 

Assuming  a  uniform  volume  of  deposits  for  each  day 
of  the  month,  this  arrangement  is  advantageous  to  the 
bank  as  against  its  depositors  in  the  ratio  of  2  to  1. 

Third.  Savings  banks  quite  generally  provide  that 
deposits  made  between  the  first  and  fifth  day  of  the  month 
shall  draw  interest  from  the  first,  while  deposits  made  after 
the  fifth  shall  draw  interest  from  the  first  day  of  the  fol- 
lowing month. 

Assuming  a  uniform  volume  of  deposits  for  each 
day  of  the  month,  this  arrangement  is  to  the  ad- 
vantage of  the  bank  as  against  its  depositors  in  the 
ratio  of  5  to  1. 

Fourth.  Some  banks  allow  interest  on  savings  accounts 
only  by  full  calendar  months. 

Fifth.  Some  banks  provide  that  if  the  depositor  makes 
a  withdrawal  during  any  semiannual  interest  period,  he 
thereby  loses  all  interest  which  may  have  accrued  thereon 
since  the  last  interest  date. 


526 


AUDITING 


This  rule  works  largely  to  the  profit  of  the  banks  and 
to  the  loss  of  the  depositors. 

As  to  how  far  an  auditor  may  wish  to  criticize  these 
rules  is  a  question  for  individual  determination.  The  fact 
is,  however,  that  most  business  men  know  nothing  about 
the  customs  with  respect  to  interest.  They  can  negotiate 
for  a  low  rate  of  interest  on  loans  or  a  high  rate  on  depos- 
its, but  they  do  not  know  that  their  bank  may  have  estab- 
lished arbitrary  interest  rules  which  yield  them  a  greater 
profit  than  other  banks  exact.  It  may  therefore  be  proper 
for  the  auditor  to  examine  into  the  whole  matter  and 
report  thereon  to  the  client. 

Custom  Among  Business  Houses 

Business  and  commercial  houses  as  a  rule  count  only 
the  first  or  last  day,  but  not  both,  when  they  figure 
interest. 

Custom  Among  Stock-Brokers 

Stock-brokers  settle  purchases  the  day  following  the 
sale,  and  they  debit  the  customer's  account  on  the  day  of 
settlement.  In  charging  monthly  interest  to  the  cus- 
tomer, the  broker  includes  both  the  day  of  settlement 
and  the  last  day  of  the  month.  The  broker  justifies  this 
by  showing  that  he,  in  turn,  is  compelled  to  pay  interest 
on  his  loan  to  the  bank  in  like  manner  by  including  both 
the  terminal  days  of  the  period  in  his  calculation. 

The  stock-broker,  by  rendering  accounts  monthly  and 
calculating  interest  for  the  same  period,  compounds  the 
interest  monthly. 

New  York  Clearing  House 

In  its  of^cial  announcements,  the  New  York  Clearing 
House  includes  the  first  day  only  and  excludes  the  last 
day. 


INTEREST  527 

The  Treasury  Department  of  the  United  States 

In  the  Treasury  Department  it  is  provided  that: 
''Only  one  of  the  two  days  of  date  and  due  date  of  an  obli- 
gation is  taken  into  account  in  stating  the  time  for  which 
interest  is  to  be  calculated." 

The  Unit  Period 

Interest,  either  expressly  or  impliedly,  is  at  such  a  rate 
"per  annum." 

Where  the  interest  runs  for  one  month,  quarterly,  or 
semiannually,  the  proportion  is  one-twelfth,  one-fourth, 
or  one-half  of  a  year. 

A  month  is  held  to  be  one-twelfth  of  the  year,  no  mat- 
ter whether  the  month  have  twenty-eight,  twenty-nine, 
thirty,  or  thirty-one  days. 

Both  of  the  foregoing  rules  are  in  force  universally 
and  are  sanctioned  by  the  rules  of  the  United  States 
Treasury  Department. 

Where  the  interest  runs,  however,  for  so  many  days, 
there  is  a  sharp  diversity  of  opinion  as  to  whether  a  cal- 
endar year  of  365  days  (366  days  for  a  leap  year)  or  an 
artificial  year  of  360  days  is  the  proper  unit  of  calculation. 

The  New  York  Clearing  House  calculates  interest  on 
the  basis  of  360  days  to  a  year.  For  instance,  the  interest 
on  $1,000  from  January  1,  1912,  to  March  12,  1912,  at  4 
per  cent  per  annum  was  officially  calculated  as  $7.89.  This 
represented  71  days  on  a  360-day-to-the-year  basis. 

It  has  also  been  held  by  the  courts  that  the  artificial 
year  of  360  days  is  a  proper  basis.  State  Bank  of  North 
Caroline  v.  Cowan,  8  Leigh  238  (Court  of  Appeals  of 
Virginia,  1837). 

But  the  better  rule,  at  least  in  modern  times,  would 
seem  to  be  that  the  calendar  year  of  365  days  is  the  proper 
basis. 


528 


AUDITING 


N.  Y.  Firemen  Ins.  Co.  v.  Ely,  2  Cowen  705  (Supreme 
Court  of  New  York,  1824),  held  that  taking  interest  on 
the  basis  of  360  days  to  the  year  was  usury. 

Chapter  148  of  the  Acts  of  Massachusetts  of  1909, 
approved  March  6,  1909,  entitled  ''An  Act  Relative  to  the 
Computation  of  Interest  on  Bonds  and  Notes  in  Dealings 
with  the  Commonwealth,"  makes  the  year  of  365  days 
the  standard  for  all  loans  to  or  by  the  Commonwealth. 

After  many  vicissitudes,  the  state  of  New  York  now 
has  in  force  the  following  (Sec.  58  of  the  General  Con- 
struction Law  of  New  York): 

The  term  years  in  a  statute,  contract,  or  any  public  or  private 
instrument,  means  365  days,  but  the  added  day  of  a  leap  year  and 
the  day  immediately  preceding  shall,  for  the  purpose  of  such  com- 
putation, be  counted  as  one  day  .  .  .  the  term  year  means 
twelve  months,  the  term  half  year,  six  months,  and  the  term 
quarter  of  a  year,  three  months. 

The  rules  of  the  Treasury  Department  of  the  United 
States  Government  are  as  follows: 

In  calculating  interest  for  a  fractional  period,  the  time  is  the 
true  fraction  of  that  period.  For  an  annual  rate,  the  time  is  the 
exact  number  of  days  for  which  the  interest  runs  divided  by  the 
number  of  days  in  the  year,  365  or  366;  for  a  semiannual  or 
quarterly  period,  it  is  the  number  of  days  for  which  the  interest 
runs  divided  by  the  number  of  days  in  the  particular  half  year  or 
quarter  year. 

Unless  the  unit  period  is  a  month,  the  month  does  not  enter 
into  interest  computations,  only  days  and  the  full  unit  period  being 
considered. 

The  rule  just  enunciated  is  somewhat  at  variance  with 
the  rule  generally  obtaining  on  bonds  or  mortgages 
where  the  interest  accrues  regularly,  as  for  example, 
quarterly  or  semiannually.  There,  when  interest  is  com- 
puted for  a  part  of  such  quarterly  or  semiannual  period, 
it  is  the  usual  custom  to  state  the  time  in  months  and 


INTEREST  529 

days  rather  than  entirely  in  clays.  In  such  a  calculation 
the  number  of  full  months  from  the  initial  date  to  the 
same  numbered  day  of  the  month  next  preceding  the 
final  date  should  first  be  ascertained,  and  then  the  odd 
days  to  the  final  date. 

When  we  figure  these  odd  days,  there  are  two  ways 
of  making  the  computation. 

First.  They  may  be  taken  at  so  many  thirtieths  of  a 
month  (on  the  360-day  basis). 

Second.  They  may  be  taken  as  so  many  twenty- 
eighths,  twenty-ninths,  thirtieths,  or  thirty-firsts,  according 
to  the  month  in  which  they  fall. 

Third.  They  may  be  taken  as  so  many  three  hundred 
and  sixty-fifths  of  a  year. 

It  is  not  assumed  by  any  means  that  the  foregoing  dis- 
cussion covers  the  question  of  interest  at  all  exhaustively, 
but  the  author  hopes  that  the  customs  and  decisions  re- 
viewed will  enable  a  student  or  practitioner  to  substan- 
tiate any  criticisms  which  he  may  deem  proper  to  make 
during  the  progress  of  an  audit. 


CHAPTER    XXIII 

SPECIAL  POINTS   IN   DIFFERENT   CLASSES   OF 

AUDITS 

Introductory 

It  is  impracticable  to  discuss  in  one  book  all  the  special 
points  which  arise  in  the  audit  of  various  enterprises.  The 
general  principles  which  underlie  all  audits  have  received 
full  consideration  and  the  rules  which  have  been  formulated 
will  serve  as  a  working  program  for  the  audit  of  any  con- 
cern. Nevertheless,  it  is  of  great  value  to  a  practitioner  to 
acquire  special  knowledge  of  as  many  kinds  of  business  as  is 
feasible. 

The  knowledge  of  the  possible  weak  spots  and  the  points 
of  greatest  importance  in  any  given  audit  enables  an  auditor 
to  make  a  better  start  than  if  his  equipment  consists  solely 
of  a  knowledge  of  general  principles. 

Human  activity,  so  far  as  the  relation  of  one  person  to 
another  is  concerned,  finds  expression  in  the  universal 
medium  of  exchange — ^money ;  and  the  records  of  any  or  all 
of  these  activities,  no  matter  how  well  or  poorly  kept  they 
may  be,  constitute  the  field  of  the  professional  auditor. 

The  various  classes  of  accounts  with  which  an  auditor 
has  to  deal  are  : 

Financial 

Insurance 

Manufacturing 

Mining 

Trading 

Transportation 

Public  utilities 

530 


BANKS 


531 


Governmental 
Executors  and  trustees 
Institutional 
Professional 
Miscellaneous 

The  foregoing  groups  will  be  considered  with  reference 
to  those  points  only  in  which  peculiar  conditions  exist  or 
where  special  emphasis  is  required.  No  attempt  will  be 
made  to  cover  any  class  of  business  in  detail. 

FINANCIAL 
National  and  State  Banks 

In  recent  years  the  subject  of  bank  examinations  has 
received  much  more  attention  than  formerly.  This  is  largely 
due  to  the  passing  away  of  the  opinion  once  held  by  many 
bank  directors  that  the  examinations  made  by  government 
examiners  for  the  Comptroller  of  the  Currency  and  for  the 
banking  commissioners  of  the  various  states  covered  all 
that  was  necessary  in  the  way  of  inspection  of  a  bank's 
condition  and  accounts. 

The  status  of  national  bank  examinations  probably  will 
undergo  some  change  in  the  future  arising  out  of  the  de- 
velopment of  the  federal  reserve  act.  The  section  of  the 
law  relating  to  national  bank  examiners  provides  for  their 
appointment  and  control  by  the  Comptroller  of  the  Cur- 
rency, but  their  salaries,  which  were  formerly  paid  in  fees, 
are  now  fixed  by  the  Federal  Reserve  Board.  While  the 
Comptroller  of  the  Currency  is  required  by  law  to  have 
examinations  made  of  all  national  banks  several  times 
each  year,  the  Federal  Reserve  Board  has  authority  to 
order  special  examinations  whenever  it  desires.  As  a 
matter  of  fact,  the  examiners  of  the  Comptroller's  office 
are  now  actually  examining  all  national  banks,  while  the 


^32  AUDITING 

examiners  of  the  Federal  Reserve  Board  are  examining 
all  federal  reserve  banks,  and  the  thirty  or  more  state  banks 
which  have  joined  the  federal  reserve  system.  While  there 
is  no  duplication  of  work,  one  must  be  struck  by  the  fact 
that  the  examining  authority  of  banks  is  not  centralized 
or  unified. 

Despite  these  governmental  examinations,  reports  of 
bank  failures  and  defalcations  are  frequent,  and  subsequent 
investigation  has  often  brought  out  the  fact  that  the  defalca- 
tions had  been  more  or  less  cleverly  concealed  for  a  period 
of  years. 

Government  examiners  should  not  be  too  sharply 
criticized  for  their  failure  to  detect  such  conditions,  as  the 
time  allowed  for  separate  examinations  is  limited,  and  it  is 
physically  impossible  for  them  to  make  thorough  audits 
within  the  time  available.  Again,  it  must  be  remembered 
that  the  chief  object  of  these  examinations  is  to  ascertain 
that  the  banks  are  solvent  and  are  complying  with  the  law. 
Some  degree  of  protection  is  afforded  depositors  by  these 
examinations,  but  the  examiners  do  not  represent  the  stock- 
holders or  the  directors,  and  the  directors  should  not  regard 
the  work  of  the  examiners  as  being  done  for  their  benefit. 

Official  examiners  recognize  this  state  of  affairs  and  are 
making  a  determined  effort  to  improve  the  unsatisfactory 
conditions  which  exist. 

The  New  York  Times  reported  a  meeting  of  the  official 
examiners  in  its  issue  of  July  9,  1912,  as  follows: 

Low  Pay  Endangers  Bank  Examinations 

Paltry   Fees    for    Inspection   of    Country    National    Banks    Result   in 

Slurring  of  Work 

Dishonesty  Is  Undetected 

The  subject  that  received  the  most  attention  in  the  meetings  was 
the  low  rate  of  pay  of  the  national  examiner  working  in  the  country, 


BANKS 


533 


both  from  the  standpoint  of  its  inadequacy  and  from  that  of  the  cor- 
responding menace  to  depositors,  caused  by  the  hurried  way  in  which 
he  must  complete  his  task  and  get  on  to  the  next  town,  if  he  is  to  make 
enough  to  pay  for  his  keep  and  travehng  expenses.  It  seems  that  the 
rate  of  compensation  was  fixed  in  1875  and  has  never  been  changed. 

For  examining  a  bank  with  less  than  $100,000  capital  the  examiner 
gets  $20.  At  least  two  days,  it  was  declared  yesterday,  should  be  de- 
voted to  a  thorough  examination,  and  sometimes  it  is  necessary  to  em- 
ploy an  assistant.  All  this  comes  out  of  the  $20,  including  the  assistant 
and  his  expenses.  The  rate  advances  with  the  size  of  the  bank,  but 
never  gets  up  very  high.  For  a  bank  capitalized  at  $100,000  to  $300,000 
the  fee  is  $25 ;  for  a  $300,000  bank,  $35 ;  for  a  $400,000  bank,  $40 ;  for  a 
$500,000  bank,  $50,  and  for  a  bank  capitalized  at  $600,000  or  over,  $75. 

A  recent  defalcation  in  this  state  was  cited  as  an  instance  of  what 
may  happen  under  a  system  where  the  national  bank  examiner  has  not 
time  and  cannot  afford  to  take  time  to  make  much  more  than  a  super- 
ficial inspection.  One  of  the  officers  had  been  robbing  this  bank  for 
years,  his  peculations  aggregating  some  $350,000.  It  had  been  examined 
by  three  or  four  different  men  in  that  time,  but  none  of  them  had  found 
anything  wrong,  and  one  of  the  examiners  said  yesterday  that  this 
affair  was  the  worst  black  eye  the  government  examining  system  had 
received  in  many  years. 

Because  of  the  agitation  for  government  guarantee  of 
bank  deposits,  in  which  case  losses  would  prohably  be  paid 
from  a  fund  sustained  by  a  tax  levied  against  the  banks, 
the  latter  have  in  some  large  cities  made  a  determined 
efifort  to  allay  public  feeling  by  decreasing  the  number  and 
size  of  bank  failures.  The  outcome  of  these  efforts  has 
been  that  in  some  cities  all  of  the  local  banks  clearing  their 
cheques  through  the  clearing  house  are  now  examined 
periodically  by  a  salaried  examiner  appointed  by  the  clearing 
house  association. 

Clearing  house  examiners  have  been  appointed  in  com- 
paratively few  cities,  and  in  some  quarters  much  opposition 
has  been  shown  toward  the  movement,  as  it  is  argued  that 
so  long  as  a  bank  is  solvent  and  is  permitted  by  the  govern- 
ment to  continue  business,  it  should  have  the  privilege  of 
naming  its  own  independent  auditor,  and  that  the  in  forma- 


^24  AUDITING 

tion  received  and  reports  rendered  by  such  auditors  should 
not  be  in  the  hands  of  anyone  with  discretionary  power  to 
discuss  the  bank's  affairs  with  competitors  who  are  mem- 
bers of  the  clearing  house  association  committee. 

While  the  examinations  made  by  clearing  house  exam- 
iners are  usually  quite  thorough,  they  will  in  all  probability 
be  limited  to  a  few  of  the  larger  cities,  as  in  small  cities 
and  rural  communities  no  clearing  house  associations  exist. 

Some  states  require  semiannual  examinations  to  be  made 
by  committees  of  directors  of  each  bank,  with  liberty  to  the 
committee  to  employ  professional  accountants  for  the  pur- 
pose, the  latter  to  report  to  the  committees  and  the  com- 
mittees to  report  to  the  state. 

The  following  quotation  from  an  address  by  James  B. 
Forgan,  president  of  the  First  National  Bank  of  Chicago, 
delivered  on  September  17,  1909,  at  the  Convention  of  the 
American  Bankers'  Association,  at  Chicago,  is  of  especial 
interest,  as  it  refers  to  the  responsibility  of  bank  directors 
and  the  necessity  for  the  employment  by  them  of  competent 
auditors  to  make  investigations : 

The  same  ordinary  prudence  which  men  exercise  in  their  own 
affairs  is  required  of  bank  directors.  The  application  of  it  differs  with 
the  varying  circumstances  of  the  banks.  Just  as  men  of  small  or 
moderate  affairs  can  undertake  the  personal  management  in  detail  of 
their  own  businesses,  while  those  of  large  affairs  must  of  necessity 
employ  others  to  manage  for  them  and  must  relieve  themselves  of 
details,  so  bank  directors,  under  similar  circumstances,  may  assume  the 
details  of  management  or  appoint  others  to  do  so.  Their  delegating 
authority  to  others  does  not,  however,  relieve  them  of  responsibility 
for  the  direction  and  supervision  of  the  management  or  of  keeping 
in  touch  with  what  is  done.  In  banks  of  moderate  size  this  can  be 
accomplished  by  committees.  In  the  largest  banks,  however,  it  be- 
comes necessary  for  the  directors  to  delegate  even  the  details  of  their 
supervisory  duties  to  experts  and  to  rely  on  their  investigations  and 
reports  for  an  intelligent  knowledge  of  what  is  being  done  and  of 
their  bank's  condition.  Systematic  organization  is  necessary,  whether 
a  bank  is  small  or  large,  and  directors  must  see  to  it  that  one  of  its 


BANKS 


535 


results  is  that  they  are  kept  fully  posted  as  to  the  bank's  operations 
and  condition.  This  can  be  accomplished  quite  as  effectively  in  large 
as  in  small  banks  through  the  employment  of  competent  auditors, 
either  permanently  or  when  they  are  wanted.  Such  auditors,  in  their 
investigations,  should  represent  the  directors  and  should  report  direct 
to  them,  uninfluenced  by  any  of  the  executive  officers.  But,  however 
it  may  be  accomplished,  it  is  up  to  the  directors  to  keep  themselves 
posted  as  to  their  bank's  operations  to  the  extent  of  enabling  them  to 
form  a  correct  opinion  of  actual  conditions  in  them  and  to  judge  of 
the  integrity  and  ability  of  the  management,  as  it  is  conducted  by  the 
officers  to  whom  they  have  delegated  managerial  powers.  Only  thus 
can  they  intelligently  exercise  their  control  of  the  management,  a  re- 
sponsibility from  which  there  can  be  no  escape. 

The  auditor  engaged  to  examine  the  affairs  and  accounts 
of  a  bank  should  procure  a  copy  of  the  statement  pubHshed 
by  it  in  response  to  the  latest  call  of  the  Comptroller  of  the 
Currency  or  the  State  Banking  Commissioner.  A  careful 
scrutiny  of  this  statement  will  give  him  a  good  idea  of  the 
volume  of  the  work  and  nature  of  the  assets  and  liabilities 
w^hich  will  shortly  demand  his  attention. 

The  audit  should  be  started  without  notice  to  either 
officers  or  employees  of  the  bank,  and  a  large  staff  should 
be  available  so  that  all  the  changeable  assets  can  be  examined 
on  the  first  day. 

Cash  and  Securities 

The  verification  of  the  balance  sheet  items  should  receive 
attention  first.  This  involves  the  actual  count  and  examina- 
tion of  such  assets  as  may  be  actually  on  hand,  and  compari- 
son thereof  with  the  general  ledger  accounts;  the  inde- 
pendent outside  confirmation  by  correspondence  of  such  of 
the  assets  as  admit  of  such  verification ;  and  a  thorough  test 
of  the  integrity  of  every  other  account  in  the  general  ledger. 

If  there  is  a  large  quantity  of  cash  on  hand  and  the 
entire  staff  must  be  used  to  count  it,  the  other  changeable 
assets,  such  as  securities  owned  by  the  bank,  notes  dis- 


536 


AUDITING 


counted,  notes  for  secured  loans  and  the  collaterals  therefor, 
etc.,  should  be  locked  up  in  a  safe  and  the  latter  sealed,  and 
access  thereto  refused,  except  with  the  approval  of  the 
auditor,  until  they  have  been  examined. 

All  of  one  class  of  the  assets  above  mentioned  should  be 
brought  to  the  auditor  before  the  examination  of  each  is 
begun  so  as  to  prevent  duplication  in  counting;  e.g.,  all  cash 
should  either  be  brought  from  the  vaults  and  tellers'  cages 
to  one  point,  or  the  auditing  staff  should  be  so  distributed 
that  counting  of  the  cash  at  all  points  will  begin  simul- 
taneously ;  transfer,  of  cash  between  the  cages  and  the  vault 
should  be  prohibited  until  all  of  the  cash  has  been  counted 
and  the  aggregate  amount  is  proved  with  the  general  ledger 
account  therefor. 

It  is  important  that  the  genuineness  of  the  cheques  on 
hand,  which  are  to  be  sent  to  the  clearing  house,  be  verified. 
The  only  safe  method  to  accomplish  this  is  for  the  auditor 
to  insert  in  each  clearing  house  envelope  a  confirmation  slip 
(and  stamped  envelope  addressed  to  himself)  requesting 
verification  of  the  aggregate  amount  of  the  enclosed  cheques 
and  detailed  advices  as  to  any  which  may  be  returned  as 
unpaid.  The  failure  to  do  this  may  be  serious,  as  forged 
or  "fake"  cheques  may  be  returned  to  the  bank  without 
being  brought  to  the  auditor's  attention.  In  addition  to 
this,  it  is  desirable  that  the  source  of  cheques  of  large  amount 
to  be  sent  either  to  the  clearing  house  or  to  out-of-town 
correspondents,  or  to  be  collected  by  runner  on  the  following 
day,  be  ascertained,  and  that  examination  be  made  to  see 
that  the  depositor  has  received  credit  therefor. 

The  method  of  making  investments  should  be  investi- 
gated by  the  auditors.  Generally  the  investing  of  the  in- 
stitutions' funds  must  be  authorized  by  a  committee;  if 
such  is  the  case,  then  the  minutes  of  such  committee's  meet- 
ings should  be  examined  and  a  notation  made  of  the  regu- 


BANKS 


537 


larity    or    irregularity    of    directors'    attendance    at    such 
meetings. 

Correspondents*  Accounts 

Accounts  current  should  at  once  be  requested  (to  be 
sent  direct  to  auditor)  from  reserve  agents  and  out-of- 
town  correspondents  with  which  the  client  carries  deposit 
accounts.  It  is  also  important  to  make  note  of  the  last 
deposits  made  and  the  number  of  the  last  draft  drawn  by 
the  client  against  these  banks,  for  use  in  later  reconciling 
the  accounts  current  with  the  client's  records.  The  auditor 
should  examine  these  draft  books  carefully  to  ascertain  that 
none  have  been  used  out  of  consecutive  order  or  from  the 
back  of  the  book,  as  missing  drafts  may  have  been  cashed 
and  the  proceeds  counted  as  cash,  or  the  cheque  may  have 
been  included  that  very  day  with  other  cheques  and  sent  to 
another  out-of-town  correspondent  and  charged  to  the  latter 
as  a  deposit.  Defalcations  have  been  cleverly  concealed  for 
some  time  by  this  method,  as  the  account  with  the  bank  on 
which  the  draft  was  drawn  was  not  reduced  on  the  client's 
books  until  after  the  date  of  the  audit,  and  the  item  did  not 
appear  on  the  account  current  of  the  depository  until  the 
end  of  the  month. 

Confirmation  of  Demand  Notes,  etc. 

All  borrowers  on  unsecured  demand  notes  should  be 
requested  by  mail  to  confirm  the  amounts  of  their  loans 
direct  to  the  auditor.  If  any  payments  on  account  have 
been  misappropriated  and  not  indorsed  on  the  notes,  these 
confirmations  should  reveal  that  fact.  Similar  confirma- 
tions, showing  the  collateral  as  well  as  the  amount  of  the 
loans,  should  be  secured  from  borrowers  on  time  or  demand 
collateral  notes. 


538 


AUDITING 


All  securities  owned  by  the  bank  or  deposited  by  custom- 
ers as  collateral  for  loans,  should  be  carefully  examined. 
Denominations  of  stock  certificates  have  in  the  past  been  so 
cleverly  raised  as  to  deceive  bank  officials,  who  accepted 
them  as  collateral  for  loans. 

Correspondents  who  may  hold  notes  or  securities  for 
the  bank's  account  should  be  requested  to  confirm  the 
amounts  thereof  direct  to  the  auditor. 

In  the  case  of  a  national  bank,  the  Treasurer  of  the 
United  States  should  be  requested  to  confirm  the  amount  of 
bonds  held  by  him  to  secure  circulation  and  government  de- 
posits, and  the  amounts  of  the  circulation  redemption  fund, 
outstanding  circulation,  government  deposits,  and  any  bal- 
ances which  may  be  due  by  him  to  the  bank. 

Certificates  of  Deposit  and  Certified  Cheques 

The  balances  in  the  cashier's  cheques,  certificates  of  de- 
posit, and  certified  cheque  accounts,  should  each  agree  with 
the  aggregate  of  the  respective  classes  of  items  outstanding. 
In  this  connection  the  canceled  items  should  be  inspected 
and  compared  with  the  stubs  or  original  records  in  order 
that  the  auditor  may  assure  himself  that  none  posted  on 
the  ledger  as  paid  are  outstanding. 

Certificates  of  deposit  and  cashier's  cheques  should 
have  attached  a  stub  containing  a  record  of  payees  and 
amounts.  These  should  be  detached  by  the  officer  signing, 
and  deposited  by  him  in  a  locked  box  to  which  access  can 
be  had  only  by  a  staff  or  professional  auditor. 

Comparison  of  these  slips  with  the  original  records 
would  disclose  discrepancies  if  any.  Frauds  have  fre- 
quently occurred  through  the  insufficient  entry  of  deposits 
against  which  certificates  of  deposit  have  been  issued,  and 
in  some  cases  no  entry  of  the  deposits  has  been  made  in  the 
books  of  the  bank. 


BANKS  539 

Capital  Stock 

The  capital  stock  certificate  book  and  stock  ledger 
should  be  examined  and  the  aggregate  of  the  outstanding 
stock  proved  with  the  general  ledger  account.  Recently  in 
New  York  the  vice-president  of  a  national  bank  was 
arrested,  convicted,  and  sentenced  for  forgery  and  fraud  in 
connection  with  the  misuse  of  his  bank's  stock  certificates. 
He  had  torn  certificates  from  the  stock  book,  forged  the 
cashier's  name  thereto,  added  his  own  name,  and  had  de- 
posited them  as  collateral  for  a  personal  loan  from  a  large 
trust  company. 

Depositors*  Accounts 

Opinions  differ  as  to  the  responsibility  of  an  auditor  in 
connection  with  the  verification  of  depositors'  accounts.  As 
these  form  the  largest  portion  of  the  liabilities,  he  should 
make  some  effort  to  verify  their  correctness,  in  addition  to 
merely  taking  a  trial  balance  from  the  depositors  ledgers. 
He  should  ascertain  that  trial  balances  are  taken  off  regu- 
larly, that  the  ledger  clerks  are  transferred  occasionally 
from  one  ledger  to  another,  that  some  one  other  than  the 
ledger  clerks  compares  the  balances  in  the  ledgers  with  the 
pass-books  when  the  latter  are  ''settled"  and  delivered  to 
the  depositors,  and  that  the  clerk  initials  the  pass-books  and 
ledgers  as  to  correctness.  In  addition  to  this  the  bank  should 
insert  in  the  pass-books  a  form  of  confirmation  of  the  de- 
positors' balance,  which  should  be  carefully  filed  when 
signed  and  returned  by  the  depositors. 

The  auditor  should  mail  statements  of  their  balances  to 
all  depositors  with  inactive  accounts,  should  verify  the 
settlements  of  all  pass-books  in  the  bank,  send  out  requests 
for  pass-books  of  all  other  active  accounts,  and  verify  the 
settlements  of  the  latter  when  received  and  balanced.    It  is 


^^O  AUDITING 

hardly  to  be  expected  that  every  depositor  will  send  in  his 
confirmation  or  pass-book  promptly,  and  it  will  be  necessary 
for  the  auditor  to  keep  a  list  of  all  depositors,  on  which  to 
make  note  of  those  accounts  which  have  been  verified,  and 
which  may  be  used  as  a  guide  at  future  dates  for  the  con- 
firmation of  all  accounts. 

In  comparing  pass-books  with  the  ledgers,  it  is  im- 
portant not  only  that  the  balances  be  compared,  but  that  the 
deposit  entries  in  the  pass-books  for  some  time  prior  to  the 
settlement  date  be  examined.  This  will  disclose  any  ledger 
cross-entries  which  may  have  been  made  and  which  should 
be  especially  investigated.  They  should  not  be  permitted, 
except  upon  officially  signed  debit  or  credit  slips,  as  defalca- 
tions have  been  cleverly  concealed  through  the  use  of  such 
cross-entries. 

In  banks  where  the  practice  of  balancing  pass-books  has 
been  superseded  by  the  system  of  rendering  monthly  ac- 
counts current  to  depositors  and  returning  to  them  at  the 
same  time  all  paid  cheques,  the  auditor  should  compare  the 
statements  with  the  ledgers,  enclose  his  confirmation  form, 
and  mail  them  himself. 

Verification  of  Income 

Tests  should  be  made  to  ascertain  that  the  bank  is  receiv- 
ing at  proper  times  and  in  correct  amounts  the  income  on  its 
securities  and  interest  on  the  loans  it  has  made  or  notes  it 
has  discounted.  Almost  all  banks  include  discounts  among 
their  earnings  as  soon  as  the  notes  are  discounted,  and  the 
conservative  and  proper  method  of  carrying  reserve  for 
unearned  discounts  is  not  generally  followed.  In  the  Middle 
West,  however,  a  number  of  large  institutions  now  show 
such  a  reserve  in  their  balance  sheets,  and  it  is  to  be  hoped 
that  in  time  the  practice  will  become  general. 


BANKS  ^41 

Expenses 

The  details  of  the  charges  to  expense  accounts  should  be 
scrutinized,  the  unusual  items  thoroughly  investigated,  and 
tests  made  of  the  correctness  of  the  usual  ones.  The  salary 
rolls  should  be  checked  and  thorough  tests  should  be  made 
of  the  correctness  of  interest  paid  on  deposits.  Postage 
stamp  payments  are  usually  large  and  should  receive  careful 
attention. 

Secret  Reserves 

If  these  are  found,  they  should  be  noted  in  the  auditor's 
report  if  the  audit  is  made  for  the  first  time.  Such  reserves 
are  hidden  in  various  ways,  generally  in  understating  on  the 
books  the  value  of  the  banking  house  or  in  carrying  an  ac- 
count in  the  depositors  ledgers.  This  latter  method  should 
be  discouraged,  as  only  bona  fide  depositors'  accounts  should 
appear  in  these  ledgers. 

Internal  Checks 

The  auditor  should  carefully  investigate  all  of  the  bank's 
methods  of  conducting  its  affairs,  for  the  purpose  of  ascer- 
taining that  the  work  is  so  divided  and  carried  out  as  to 
reduce  to  a  minimum  the  opportunity  for  fraud,  and  that 
in  so  far  as  possible  the  system  in  use  provides  for  internal 
check  on  the  integrity  of  the  accounts. 

Employees  handling  cash,  securities,  notes,  or  cheques 
should  not  have  access  to  or  assist  in  writing  up  or  proving 
the  general  bookkeeping  records,  nor  should  bookkeepers 
have  access  to  the  records  of  the  tellers.  Clerks  making 
original  entries  should  not  see  the  records,  which  are  a 
check  on  those  entries,  and  so  far  as  possible  the  clerks 
should  occasionally  be  transferred  from  one  set  of  records 
to  another,  so  that  if  fraud  be  committed,  it  cannot  remain 
concealed  for  any  length  of  time.     Ledger  transfers  and 


^42  AUDITING 

other  unusual  entries  should  not  be  permitted  except  upon 
written  order  bearing  official  signature. 

Scope  of  Report 

The  auditor's  report  should  be  very  complete,  including 
not  only  statements  of  the  bank's  condition  and  income  and 
expense  accounts  for  the  period  under  review,  but  also  de- 
tailed statements  of  the  securities  owned,  collateral  loans 
and  value  of  collateral,  single  name  and  indorsed  paper,  and 
total  liability  of  each  borrower.  He  should  also  call  particu- 
lar attention  to  any  memoranda  which  may  have  been  carried 
as  cash,  all  overdue  notes,  insufficiently  secured  collateral 
loans,  loans  to  officers  and  employees,  overdue  interest,  and 
uncollected  income  on  securities. 

The  auditor  should  bear  in  mind,  when  examining  the 
affairs  and  accounts  of  banks  and  financial  institutions  gen- 
erally, that  his  certificate  will  be  regarded  as  an  assurance 
of  the  reliability  of  the  statement  so  certified,  and  that  while 
he  does  not  guarantee  the  security  of  the  deposits  made*  by 
the  public,  the  latter  will,  and  justly  so,  severely  criticize 
him  if  subsequent  developments  show  that  at  the  time  of  his 
examination  the  bank  was  insolvent,  but  that  his  report  did 
not  reveal  the  fact. 

Instances  of  Fraud 

Defalcations  are  especially  to  be  guarded  against  in 
financial  institutions.  The  following  are  some  of  the 
schemes  which  have  been  used  by  defaulters. 

A  note  teller  in  a  bank,  in  order  to  cover  up  cash  ab- 
stracted, would  increase  the  amount  of  total  of  loans  made 
for  the  day.  He  would  turn  in  to  the  general  bookkeeper, 
accompanying  his  voucher,  an  adding  machine  list  which,  if 
it  had  been  footed,  would  have  been  found  not  to  be  the 
same  as  the  total  shown  by  the  adding  machine.     Later 


BANKS 


543 


on,  at  such  times  as  the  accounts  were  examined  and  the 
notes  proved  either  by  a  bank  examiner  or  others,  he  would 
put  in  forged  notes  to  cover  the  amount  short,  using  the 
name  of  some  concern  which  had  a  good  Hne  of  credit  with 
the  bank. 

A  note  teller  started  in  this  way  by  taking  about  $200 
and  was  finally  short  $7,000.  He  made  no  false  entries  in 
the  books,  outside  of  the  adding  machine  list  and  the  total 
of  the  daily  ticket  which  he  turned  in  to  the  general  book- 
keeper. The  defalcation  was  not  discovered  until  the  bank 
was  merged  with  another  bank.  If  the  notes  had  ever  been 
checked  back  with  the  original  discount  register,  it  would 
have  been  found  that  the  forged  notes  were  not  entered 
therein. 

Another  note  teller,  among  whose  duties  it  was  to  send 
out  items  for  collection,  would  abstract  cash  and  enter  in 
his  accounts  certain  items  as  being  out  for  collection.  These 
items  he  represented  to  be  notes  deposited  for  collection  for 
which  he  had  paid  cash,  and  the  record  was  made  to  show 
that  the  notes  were  on  some  distant  point  which  would 
take  several  days  for  return.  In  doing  this  he  always  used 
the  name  of  some  good  customer  whose  line  of  credit  was 
unquestionable.  This  practice  went  on  for  a  long  time 
until  a  bank  examiner,  who  had  been  over  the  accounts 
several  times  before,  happened  to  question  the  teller  about 
one  of  these  particular  items  at  a  time  when  the  teller  had 
just  returned  after  a  few  days'  absence  from  the  bank.  The 
teller  became  nervous  and  somewhat  evasive  in  his  answers. 
The  examiner  then  wrote  to  the  firm  whose  name  was  used 
in  connection  with  these  items  and  found  they  had  deposited 
no  such  items  for  collection. 

In  this  connection  the  auditor  would  have  discovered 
the  true  condition  if  he  had  verified  the  outstanding  items 
for  collection,  either  by  correspondence  with  the  bank  to 


544  AUDITING 

which  the  collection  was  sent,  or  by  writing  to  the  in- 
dividual or  firm  who  it  was  claimed  had  deposited  the  item. 

Another  bank  teller  in  a  large  bank  opened  an  account 
with  a  small  bank  in  another  part  of  the  city.  He  would 
draw  cheques  on  the  bank  in  which  he  worked,  using  some 
fictitious  name,  and  deposit  them  in  the  bank  in  which  he 
had  an  account.  When  those  cheques  came  in  through 
the  clearing  house  to  the  bank  in  which  he  worked,  they 
came  to  him  and  he  would  promptly  tear  them  up.  At 
the  end  of  the  day  his  department  would  be  short  and  this 
shortage  would  be  charged  to  an  ''over  and  short"  account, 
as  would  other  items,  until  such  time  as  the  errors  would 
be  discovered,  when  they  would  be  taken  out  of  this 
account. 

He  continued  this  practice  over  a  long  period,  taking 
small  amounts,  till  the  fraud  was  discovered,  when  the 
bank's  "over  and  short"  account  amounted  to  some  $40,000, 
a  part  of  which  represented  the  stealings  of  this  teller; 
but  it  was  not  known  just  how  much.  It  was  extreme 
carelessness  on  the  part  of  the  bank  to  allow  such  an  ac- 
count to  assume  large  proportions.  The  bank  stated  that 
there  were  certain  losses  which  it  could  not  guard  against, 
and  it  estimated  that  these  losses  would  amount  to  several 
thousand  dollars  a  year,  no  matter  what  precautions  it  might 
take. 

A  cashier  abstracted  from  a  bank  $120,000  by  the  use 
of  fraudulent  certificates  of  deposit  of  which  he  had  dupli- 
cates printed  and  numbered. 

An  individual  who  was  treasurer  of  a  savings  bank 
and  cashier  of  a  national  bank,  entered  savings  items  in 
depositors'  pass-books  but  not  on  the  books  of  the  bank. 
He  also  carried  memoranda  as  cash;  when  examiners  ap- 
peared he  took  enough  from  the  national  bank's  funds  to 
temporarily  make  good  the  cash  shortage. 


BANKS 


545 


The  following  extract  from  the  (New  York)  National 
City  Bank's  July,  1912  circular  is  of  particular  interest 
in  that  it  contains  the  suggestions  made  by  the  Comp- 
troller of  the  Currency  to  examining  committees  of  national 
banks : 

Bank  Examinations  by  Directors.  On  June  1  the  Comptroller  of 
the  Currency  requested  the  boards  of  directors  of  national  banks  to 
send  to  his  office  a  copy  of  the  reports  of  the  annual  or  semiannual 
examinations  made  by  the  examining  committees  or  by  other  parties  at 
the  instance  of  the  directors,  and  not  a  single  bank  has  declined  to 
comply  with  such  request. 

A  review  of  the  reports  that  have  been  received  shows  that  many 
of  these  examinations  are  deficient  in  their  scope  and  that  many 
features  essential  to  a  thorough  understanding  of  the  bank's  affairs  are 
not  covered.  As  heretofore  pointed  out  in  this  circular,  a  number  of 
states  have  provided  by  law  for  reports  by  the  examining  committees 
of  state  banks  to  their  state  banking  departments,  and  in  these  states  a 
form  of  report  has  been  prepared  for  that  purpose.  At  the  beginning, 
however,  the  Comptroller  of  the  Currency  does  not  intend  to  prescribe 
a  form  for  the  directors  to  use  in  making  reports  to  his  office,  or  to 
require  examinations  of  a  technical  character,  but  rather  to  offer  such 
suggestions  as  will  lead  to  really  effective  examinations.  The  following 
list  of  general  points  to  be  covered  has  been  drafted  by  the  Comptroller 
with  a  view  to  sending  the  same  to  those  banks  where  the  report  of 
the  examining  committee  shows  the  examination  to  be  superficial : 

1.  The  cash  should  be  counted  and  the  total  compared  with  the 
books  of  the  bank.  Cash  items  should  be  carefully  scrutinized,  and  any 
improper  items,  such  as  unposted  cheques  held  for  the  purpose  of  not 
showing  overdrafts,  and  any  other  items  that  cannot  be  readily  con- 
verted into  cash,  should  be  reported. 

2.  The  bonds  and  other  securities  of  the  bank  should  be  examined 
and  those  not  on  hand  should  be  verified  by  reference  to  the  receipts 
of  the  parties  with  whom  they  are  deposited.  The  market  value  and 
the  amount  at  which  carried  on  the  books  in  the  aggregate  should  be 
shown,  and  any  stocks  held  by  the  bank  should  be  listed  with  a  state- 
ment showing  the  reasons  the  securities  were  taken  by  the  bank. 

3.  The  notes  should  be  carefully  checked  and  their  total  compared 
with  the  general  ledger.  The  genuineness,  value,  and  security  of  each 
note,  and  of  any  collateral  thereto,  should  be  carefully  determined,  and 
any  losses  ascertained,  or  probable,  in  the  judgment  of  the  committee, 
should  be  noted.    The  liabilities  of  each  of  the  larger  borrowers,  and 


-^5  AUDITING 

loans  to  affiliated  interests,  should  be  aggregated  and  carefully  consid- 
ered. The  report  should  also  show  the  general  character  of  the  loans; 
whether  well  distributed;  the  general  character  of  the  collaterals; 
whether  corporations  in  which  officers  or  directors  are  interested 
borrow  to  an  undue  extent;  also  any  large  liabilities  of  the  officers 
or  directors.  It  should  also  be  shown  whether  all  paper  claimed  by 
the  bank  as  its  own  property,  including  collaterals,  is  properly  in- 
dorsed or  assigned  to  it,  and  all  mortgages  recorded.  Any  loans  ex- 
ceeding 10  per  cent  of  the  capital  and  surplus  of  the  bank  should  be 
reported.  The  signatures  of  all  note  makers  and  indorsers  should  be 
carefully  scrutinized  and  any  erasures  and  alterations  or  any  indica- 
tions of  manipulation  should  be  carefully  investigated  and  reported  to 
the  full  board.  All  overdue  paper  should  be  listed  and  comment  made 
as  to  its  collectability. 

4.  The  certificates  of  deposit  and  the  cashier's  cheques  should  be 
verified  by  totaling  those  outstanding  and  as  shown  by  the  register 
and  comparing  with  the  general  ledger,  and  also  by  comparing  the  can- 
celed certificates  and  cheques  with  the  register  and  checking  them 
against  the  stubs. 

5.  The  copy  retained  by  the  bank  of  the  report  of  condition  made 
to  the  Comptroller  at  the  last  call  should  be  compared  with  the  bank's 
books  at  that  date,  particularly  with  reference  to  the  excessive  loans 
and  directors'  and  officers'  liabilities  reported  to  the  board  of  directors. 

6.  The  bank's  last  reconcilements  of  accounts  with  correspondents 
should  be  compared  with  the  bank's  books  and  a  transcript  of  the 
bank's  account  from  the  the  date  of  the  last  reconcilement  to  the  date 
of  the  examination  sent  to  the  corresponding  bank,  with  a  request  for 
verification. 

7.  Individual  ledger  balances  should  be  verified  in  such  manner  as 
the  directors  may  deem  advisable,  by  calling  in  pass-books,  by  sending 
out  reconcilements  of  certain  accounts  selected  by  the  directors,  or  in 
some  other  suitable  way.  A  trial  balance  of  the  ledger  should  be  taken 
by  some  member  of  the  committee,  or  at  least  by  some  person  other 
than  the  clerk  engaged  on  the  ledger. 

8.  Overdrafts  should  be  totaled  and  carefully  considered  and  the 
report  should  show  any  estimated  losses. 

9.  The  committee  should  consider  carefully  the  Profit  and  Loss 
and  the  Expense  account,  with  a  view  of  determining  whether  the 
charges  against  those  accounts  are  proper  and  whether  the  earnings 
of  the  bank  warrant  the  expense  charges,  and  the  bank  is  making  a 
legitimate  profit. 

10.  The  examining  committee  should  inquire  carefully  into  the  ar- 
rangement of  the  working  aflfairs  of  the  bank  and  ascertain  whether 


BANKS 


547 


any  employee  who  keeps  the  individual  ledger  receives  deposits  or 
balances  pass-books,  and  whether  the  employees  are  properly  bonded 
and  in  whose  custody  the  bonds  are  lodged. 

11.  Any  liability  of  the  bank  for  borrowed  money  should  be  listed 
and  the  proper  authority  and  the  necessity  for  such  borrowing  ascer- 
tained. The  total  amount  of  the  present  liabilities  of  that  nature  should 
be  reported  to  the  board,  including  money  borrowed  from  other  banks 
on  certificates  of  deposit. 

The  Comptroller  desires  that  the  report  of  the  directors  or  the  ex- 
amining committee  should  show  that  the  above  points  have  been 
covered  and  that  it  should  recite  any  deficiencies  discovered.  The 
report  will  also  be  expected  to  contain  a  complete  statement  of  the  total 
assets  and  liabilities  of  the  bank,  with  any  additions  or  deductions  that 
in  the  judgment  of  the  directors  should  be  made  as  a  result  of  their 
investigation;  and  a  detailed  statement  of  the  loans  which  the  directors 
estimate  as  worthless,  doubtful,  or  insufficiently  secured,  giving  reasons 
therefor,  and  as  nearly  as  possible  the  real  value.  It  is  furthermore 
desired  that  the  report  contain  a  statement  of  any  matters  which  in 
the  opinion  of  the  committee  affect  in  any  way  the  bank's  solvency, 
stability,  or  prosperity. 

The  Comptroller  believes  that  there  are  few  instances  where  the  ex- 
amining committee  cannot,  if  they  will  take  the  necessary  time,  cover 
these  points  fully  and  satisfactorily,  and  that  an  examination  twice  a 
year,  along  the  above  lines,  by  a  committee  of  the  directors  who  will 
give  sufficient  time  to  the  work  to  make  it  thorough  and  complete, 
cannot  fail  to  be  of  great  benefit  to  all  concerned,  especially  to  the 
shareholders  who  have  placed  them*  in  their  positions  of  trust. 


Savings  Banks 

The  general  procedure  in  auditing  a  savings  bank  is 
more  or  less  similar  to  that  necessary  in  auditing  a  national 
or  state  bank.  Savings  banks  are  limited  by  the  laws  of 
most  states  to  certain  classes  of  investments,  and  are  not  per- 
mitted to  discount  notes  or  to  make  unsecured  loans.  For 
this  reason  most  of  their  assets  consist  of  bonds,  mort- 
gages, and  other  long-term  investments.  At  the  time  of 
examining  the  mortgages  the  auditor  should  ascertain  that 
in  those  cases  where  the  mortgage  covers  improved  prop- 
erty, sufficient  insurance  is  carried  (payable  to  the  bank  as 


548 


AUDITING 


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c^o  AUDITING 

mortgagee)    to   protect   it   in   case   the   improvements   are 
destroyed  by  fire. 

In  many  states  the  amount  which  each  person  may  de- 
posit in  a  bank  is  hmited.  Auditors  should  endeavor  to 
ascertain  whether  any  depositors'  accounts  exceed  the  limit, 
or  if,  as  has  happened  in  some  cases,  one  person  has  more 
than  one  account  and  the  total  of  the  several  accounts  ex- 
ceeds the  limit. 

Some  trouble  will  probably  be  experienced  in  procuring 
the  addresses  of  all  the  depositors  for  the  purpose  of  send- 
ing out  requests  for  confirmations  of  their  accounts.  Any 
neglect  on  the  part  of  the  employees  to  make  every  effort 
to  get  these  addresses  and  keep  them  up  to  date,  should 
be  mentioned  in  the  auditor's  report.  Defalcations  in  sav- 
ings banks  are  more  often  concealed  through  manipulation 
of  depositors'  inactive  accounts  than  in  any  other  way. 

It  will  be  found  to  be  just  as  effective  and  less  expensive 
to  mail  to  the  depositors  a  form  of  confirmation  which 
will  require  the  depositor  to  communicate  with  the  auditor 
only  in  case  of  a  difference,  as  to  send  a  form  which 
every  depositor  must  sign  and  return.  As  a  great  many 
savings  bank  depositors  are  of  the  working  class,  usually  a 
smaller  percentage  of  the  confirmations  of  the  last-mentioned 
kind  are  returned  to  the  auditor  than  in  the  case  of  de- 
positors in  national  and  state  banks.  In  sending  the  sug- 
gested form  of  confirmation,  it  is  desirable  for  the  auditor 
to  insert  an  unstamped  envelope  for  the  depositor's  use  in 
case  he  finds  it  necessary  to  communicate  with  the  auditor. 

The  State  of  Massachusetts  requires  the  auditor  to  re- 
port the  results  of  his  examination  on  the  form  shown  on 
pages  548-549. 

Trust  Companies 

The  name  'Trust  Company"  indicates  that  it  was  the 
original  object  of  such  institutions  to  act  in  a  fiduciary 


TRUST    COMPANIES  35 1 

capacity  and  exercise  trust  functions  only.  A  few  com- 
panies still  limit  themselves  to  these  purposes,  but  most  of 
them  now  conduct  a  banking  business  in  addition  thereto. 
Their  charters  are  usually  very  liberal.  While  they  may 
not  issue  circulating  notes,  and  in  some  states  are  forbid- 
den to  discount  commercial  paper,  they  are,  on  the  other 
hand,  allowed  to  make  loans  on  real  estate,  which  privilege 
is  denied  national  banks. 

The  auditor  should  bear  in  mind  that  the  majority  of 
the  deposits  are  demand  deposits  and  he  should  not  hesi- 
tate to  call  attention  to  the  danger  of  having  large  amounts 
invested  in  assets  which  cannot  be  liquidated  readily. 

The  audit  of  the  banking  department  of  a  trust  com- 
pany should  be  conducted  along  lines  similar  to  that  fol- 
lowed in  the  audit  of  a  national  or  state  bank.  The  audit 
should,  however,  also  embrace  such  other  departments  as 
the  trust  company  may  be  operating.  These  departments 
usually  are  the  trust  fund,  safe  deposit,  bond,  real  estate, 
and  corporate  trust  departments. 

A  majority  of  the  companies  carry  controlling  accounts 
for  the  principal  of  the  trust  funds  held  by  them.  The 
auditor  should  make  tests  of  the  amounts  at  which  each 
trust  is  carried,  and  of  the  trusts  received  and  delivered 
during  the  period  under  audit.  The  details  should  be 
proved  with  the  controlling  accounts.  In  the  large  trust 
companies  there  are  many  subsidiary  records  kept  by  dif- 
ferent clerks  and  it  is  possible  to  verify,  at  least  in  part, 
the  entries  in  each  of  these  subsidiary  records. 

None  of  these  departments  should  carry  any  cash  on 
hand,  as  all  necessary  funds  should  be  deposited  with  the 
banking  department.  All  securities  which  should  be  on 
hand  must  be  accounted  for,  and  the  general  records  of 
each  department  should  be  carefully  checked.  Such  tests 
of  the  detailed  work  should  also  be  made  as  will  satisfy 


cr2  AUDITING 

the  auditor  that  the  trust  company  is  properly  accounting 
to  the  beneficiaries  of  all  trusts,  and  to  the  principals  for 
whom  it  may  be  acting  as  agents,  for  the  income  collected 
by  it. 

The  collection  of  the  trust  company's  income  from 
these  departments,  such  as  commissions  on  the  transactions 
of  the  trust  and  real  estate  departments,  income  and  profits 
on  bonds  handled  by  the  bond  department,  income  from 
safe  deposit  boxes  and  silver  storage  vaults,  and  fees  from 
corporations  whose  securities  are  handled  by  the  corporate 
trust  department,  should  be  thoroughly  tested.  The  ex- 
penses of  the  various  departments  should  also  be  given 
careful  attention. 

It  is  physically  impossible,  as  well  as  unnecessary,  in 
the  audit  of  a  large  trust  company,  for  the  auditor  to  check 
in  detail  all  of  the  transactions  during  the  audit  period, 
and  the  efficacy  of  the  internal  check  provided  by  the  sys- 
tem in  use  should  guide  him  in  determining  to  what  extent 
to  carry  the  tests  of  the  detailed  work. 

Investment  Companies 

The  theory  on  which  investment  companies  are  formed 
and  operate  is  that  by  merging  the  capital  of  many  investors 
and  distributing  it  over  a  large  number  of  investments, 
the  proportionate  risk  of  loss  incurred  by  any  one  investor 
is  very  small.  The  operation  of  the  law  of  average  also 
permits  of  investing  in  securities  yielding  a  somewhat 
higher  rate  of  income  without  the  probability  of  the  total 
capital  being  lost,  which  latter  is  not  infrequently  the  case 
with  an  individual  investor  who  may  have  but  a  small 
amount  to  invest  and  hence  cannot  distribute  it  over  a  num- 
ber of  investments.  Aside  from  holding  companies  which 
are  organized  more  for  the  purpose  of  practically  merging 
a  group  of  companies  than  for  trading  in  their  securities, 


INVESTMENT    COMPANIES  553 

investment  companies  are  much  more  common  in  Europe 
than  m  the  United  States. 

Purchases  and  sales  of  securities  should  be  verified  by 
the  brokers'  memoranda  therefor.  Especially  important  is 
it  in  this  connection  to  see  that  accrued  interest  on  bonds 
and  dividends  on  stocks  bought  or  sold  ex-dividend,  are 
properly  treated.  Entries  for  purchases  and  sales  of  securi- 
ties made  at  a  flat  price  should  be  made  so  as  to  apportion 
the  cost  of  sale  between  the  interest  or  dividend  accrued  to 
date  of  purchase  or  sale  and  the  net  capital  cost  or 
realization. 

Income  accruing  from  all  investments  held  during  the 
audit 'period  should  be  accounted  for.  The  securities  held 
at  the  date  of  the  balance  sheet  will,  of  course,  need  to  be 
examined. 

If  the  net  result  of  the  year's  changes  in  investments 
is  a  profit,  it  may  be  paid  out  in  dividends;  if  the  net 
result  is  a  loss,  it  must  be  charged  against  surplus,  unless 
a  reserve  already  exists  against  which  the  loss  may  be 
charged.  The  most  conservative  policy  for  the  treatment 
of  profits  realized  from  changes  of  investments  would  be 
not  to  credit  them' at  all  to  the  current  income  account,  but 
to  a  special  reserve  or  surplus  account  to  provide  for  pos- 
sible future  losses  on  investments  owned  which  cannot  be 
foreseen  at  the  present  time.  When  profits  on  investments 
are  treated  as  income,  they  should  be  separately  shown  in 
stating  the  income  account. 

The  complexion  of  the  balance  sheet  will  necessarily^ 
depend  very  largely  on  the  valuations  at  which  the  invest- 
ments held  are  entered  therein.  Consequently  the  verifica- 
tion of  the  investment  valuations  may  well  be  said  to  be 
the  most  important  single  feature  of  the  audit. 

Should  investments  have  been  acquired  in  exchange  for 
the  company's  own  stock  and  be  carried  on  the  books  at 


CC4  AUDITING 

values  which  are  obviously  in  excess  of  their  real  values, 
even  though  the  latter  may  not  be  definitely  ascertainable 
from  market  quotations,  it  is  clearly  the  duty  of  the  auditor 
to  call  attention  to  the  fact  that  such  investments  are  not 
being  carried  at  their  actual  value. 

Each  individual  investment  need  not  be  written  down 
to  market  value  when  there  has  been  a  fall  in  price.  If 
the  aggregate  market  values  of  all  the  investments  equal 
the  total  cost  thereof,  that  is  sufficient.  Should  the  aggre- 
gate market  values,  however,  be  less  than  cost,  it  is  preferable 
to  credit  the  net  difference  to  a  fluctuation  reserve  rather 
than  to  adjust  the  book  value  of  each  individual  investment. 
It  is  also  preferable  to  show  the  fluctuation  reserve  as  a 
deduction  ("in  short")  from  the  total  value  of  the  invest- 
ments in  the  balance  sheet,  rather  than  as  an  item  among 
the  liabilities.  This  reserve  is  not  an  actual  liability,  but 
exists  solely  for  the  purpose  of  bringing  the  book  value 
of  the  investments  down  to  market  value.  It  is  quite  in 
order  to  readjust  the  reserve  from  year  to  year  to  accord 
with  changed  market  conditions.  Care  should  be  taken, 
however,  that  reserves  for  losses  or  decreases  in  market 
values  are  not  treated  as  an  extraordinary  charge  in  the 
Profit  and  Loss  account  of  the  year  in  which  the  reserves 
are  made,  and  then  when  prices  go  up  again,  that  part  of 
the  reserve  which  is  no  longer  needed,  treated  as  ordinary 
income. 

The  book  value  of  investments  should  not  be  increased 
when  market  prices  exceed  cost.  The  same  reasons  which 
are  effectively  urged  against  the  increasing  of  plant  or 
merchandise  values  above  cost,  apply  in  valuing  the  invest- 
ments held  by  an  investment  company — in  a  sense  they 
form  both  its  plant  and  stock-in-trade.  Should  it  be  de- 
sired to  show  the  investments  at  market  values  which  are 
in  excess  of  cost,  the  excess  should  not  be  credited  to  the 


INVESTMENT    COMPANIES  555 

ordinary  income  or  surplus  account  from  which  dividends 
are  paid,  but  should  be  credited  to  a  special  reserve  or  sur- 
plus account. 

A  distinction  should  be  made  between  bo7ta  Me  invest- 
ment companies  and  speculative  securities  companies.  The 
former's  income  is  derived  principally  from  the  income 
received  from  investments  owned,  whereas  the  latter's  chief 
source  of  income  is  the  profit  realized  from  purchases  and 
sales  of  securities.  It  follows  that  the  investments  of  a 
real  investment  company  are  to  a  certain  extent  fixed  assets, 
and  that  this  may  be  taken  into  consideration  in  treating 
them  in  the  accounts,  but  that  the  investments  of  a  specula- 
tive finance  company  are  its  stock-in-trade  and  should  be 
valued  in  the  same  way  as  stock  on  hand  is  valued  in  the 
case  of  mercantile  undertakings,  viz.,  "cost  or  market,  which- 
ever is  the  lower." 

A  difficulty  which  will  frequently  be  encountered  is  that 
of  ascertaining  the  real  value  of  the  investments.  Nominal 
stock  exchange  quotations  for  securities  with  a  restricted 
market  do  not  always  indicate  the  realizable  value  of  a  large 
block  of  stocks  or  bonds.  As  already  stated  in  the  case 
of  bona  Ude  investment  companies,  the  book  values  of  the 
individual  investments  need  not  be  varied  to  conform  to 
changes  in  market  values.  The  object  in  view,  viz.,  to 
reduce  the  aggregate  book  value  of  the  investments  to  the 
aggregate  market  value  thereof,  is  just  as  effectively  ac- 
complished by  setting  up  a  reserve  for  the  difference  be- 
tween total  cost  and  total  market  value. 

Apparent  increases  in  investment  values  by  reason  of 
rising  market  prices  should  not  be  treated  as  income  until 
they  have  actually  been  realized  by  sale  of  the  securities. 
It  is  important  for  the  auditor  to  see  that  all  profits  on 
sales  of  investments  which  may  be  shown  were  actually 
realized,  and  that  they  have  not  been  brought  into  the  books 


556 


AUDITING 


by  placing  a  higher  value  on  securities  received  in  making 
exchanges.  So  far  as  possible,  the  auditor  should  also 
satisfy  himself  that  no  part  of  the  profit  shown  is  the  re- 
sult of  "wash  sales"  or  other  transactions  of  a  similar 
character. 

The  valuation  of  marketable  investments  was  well 
treated  in  A.  Lowes  Dickinson's  admirable  paper  on  "The 
Profits  of  a  Corporation"  (Proceedings  of  the  Congress 
of  Accountants,  1904,  pages  183-184). 

In  conclusion,  it  may  be  stated  that,  even  though  under 
certain  circumstances  the  payment  of  dividends  by  invest- 
ment companies  without  first  making  good  decreases  in 
the  value  of  investments  may  not  conflict  with  existing 
laws,  such  a  procedure  is  so  at  variance  with  the  canons  of 
sound  finance  that  the  auditor  should  be  certain  that  the 
published  reports,  and  particularly  his  certificate,  clearly 
show  the  actual  condition  of  afifairs. 

Stockbrokers 

Without  doubt  a  practical  knowledge  of  the  "inner 
W'orkings"  of  a  stockbroker's  office  is  valuable  to  the  audi- 
tor engaged  to  make  an  audit  of  accounts  of  this  nature, 
but  the  lack  of  such  special  knowledge  is  not  an  insuperable 
obstacle  to  a  competent  accountant.  From  good  articles 
which  quite  often  appear  in  financial  magazines,  and  from 
talks  with  stockbrokers,  a  good  idea  of  the  methods  in  use 
can  be  obtained.  It  is,  however,  important  that  prior  to 
beginning  an  audit  of  such  accounts,  the  auditor  have  a 
knowledge  of  the  books  used.  It  often  occurs  that  stock- 
brokers require  special  accounting  work  done  at  busy  pe- 
riods, and  such  work  afYords  the  future  auditor  a  good 
opportunity  to  familiarize  himself  with  the  books  of  account. 

Brokers  buy  and  sell  securities  for  customers  and,  at 
times,  for  their  own  account.     The  customers  may  pay  for 


STOCKBROKERS  557 

such  purchases  in  full  and  request  the  delivery  to  them 
of  the  securities  purchased,  or  they  may  be  carried  "on 
margin"  by  brokers  for  the  customers'  accounts.  Cus- 
tomers may  desire  brokers  to  remit  the  entire  proceeds  of 
sales  of  securities,  or  may  leave  the  proceeds  on  deposit 
with  the  brokers  for  future  use  in  purchasing  other  securities. 

Brokers,  therefore,  not  only  handle  cash,  but  securities 
as  well.  Usually  the  values  of  the  securities  carried  by 
brokers  are  many  times  larger  than  the  cash  on  hand  and 
in  bank.  Brokers  find  it  necessary  to  borrow  large  sums 
of  money  from  banks  as  collateral,  for  which  they  are 
required  to  deposit  securities,  which  in  most  cases  are  those 
which  are  being  carried  *'on  margin"  by  the  brokers  for 
their  customers.  At  times,  brokers  must  borrow  securities 
from  other  brokers,  or  may  find  it  desirable  to  lend  them 
securities.  It  is  also  necessary  to  send  securities  to  the 
transfer  offices  of  various  companies  to  have  certificates 
transferred  to  customers'  names,  and  securities  are  at  times 
deposited  with  stockholders'  or  bondholders'  committees, 
or  for  other  reasons  may  not  be  in  the  office  of  a  broker 
at  the  time  the  audit  is  begun. 

Obviously  brokers'  books  must  account  for  all  securities, 
as  well  as  for  all  cash,  and  for  this  reason  they  are  radi- 
cally different  in  form  and  nature  from  the  books  of  ac- 
count usually  found  in  other  lines  of  business.  The  books 
generally  used  in  stockbrokers'  offices  in  New  York  City 
are  the  following : 

Cash  Book.  For  recording  the  cash  receipts  and  pay- 
ments, and  the  securities  received  and  delivered. 

Clearing  House  Blotter.  For  recording  the  purchases 
and  sales  in  lots  of  100  shares  or  multiples  thereof  of 
clearing  house  stocks,  i.e.,  stocks  which  because  of  their 
activity  are  listed  by  the  stock  exchange  clearing  house, 
and  are  subject  to  its  provisions. 


558 


AUDITING 


Tickets  showing  the  details  of  transactions  in  these 
stocks  as  to  principals,  number  of  shares,  class  of  security, 
price  and  monetary  value,  are  exchanged  between  clearing 
house  members.  These  tickets  are  entered  on  a  form  pro- 
vided by  the  clearing  house  and  known  as  a  clearing  house 
sheet,  the  purchases  being  entered  on  the  left-hand  side 
and  the  sales  on  the  right-hand  side.  These  are  summar- 
ized as  to  classes  of  stocks  and  slips  prepared  for  the  net 
balances  of  stocks  to  be  received  or  delivered  the  next  day. 
These  balances  are  valued  at  prices  fixed  by  the  clearing 
house,  and  a  cheque  or  draft  is  submitted  in  settlement  of 
the  amount  due  to  or  from  the  clearing  house,  represent- 
ing the  adjustment  to  the  clearing  house  prices  of  the 
stock  balances  which  will  be  received  or  delivered  the  fol- 
lowing day. 

Delivery  of  the  individual  transactions  is  in  effect  ac- 
complished by  the  exchange  of  tickets  between  the  respective 
parties  to  the  trades,  all  contracts  being'  consummated  by 
the  receipt  or  delivery  the  next  day  of  the  net  amount  of 
each  stock  traded  in. 

In  a  majority  of  the  large  stock  exchange  houses  the 
clearing  house  blotter  is  an  exact  copy  of  the  clearing 
house  sheet,  except  that  in  addition  it  provides  columns 
for  customers'  names,  commissions,  revenue  taxes,  etc. 

Ex-Clearing  House  Blotters.  For  recording  all  ex- 
clearing  house  transactions,  i.e.,  odd  lots,  transactions  in 
ex-clearing  house  stocks,  bonds,  etc.  Some  houses  which 
have  numerous  odd-lot  transactions  with  certain  houses 
which  specialize  in  odd  lots,  have  adopted  the  practice  of 
running  a  ''sheet"  with  the  latter.  Where  such  is  the  case, 
a  separate  blotter  is  devoted  to  these  particular  transactions, 
which  bears  the  same  relation  to  its  "sheet"  as  does  the 
clearing  house  blotter  to  the  clearing  house  sheet. 

The  ex-clearing  house  blotter  also  serves  as  a  journal 


STOCKBROKERS 


559 


in  a  number  of  houses.  Where  so  used,  these  entries  are 
called  "cross  entries,"  presumably  because  no  cash  enters 
into  them.  Ordinarily  every  blotter  entry  is  offset  by  cash 
on  the  opposite  side,  expressed  either  in  entering  on  the 
credit  side  the  balance  in  the  morning  and  on  the  debit  side 
the  closing  balance  at  night,  or  by  debiting  the  receipts 
and  crediting  the  payments. 

The  best  practice,  however,  is  to  use  a  journal  for  all 
entries  other  than  cash,  and  its  use  is  growing  more  gen- 
eral with  large  stock  exchange  houses. 

In  all  of  the  blotters  above  mentioned,  columns  are 
provided  for  entering  the  commission  charged  for  execut- 
ing the  customers'  orders,  the  value  of  revenue  tax  stamps 
required  by  the  New  York  law  to  be  attached  to  certificates 
when  sold,  the  amounts  to  be  paid  to  or  received  from 
other  brokers,  and  the  amounts  to  be  charged  or  credited 
to  customers  for  the  purchases  or  sales  of  securities. 

General  Ledger.  This  ledger  contains  the  various  asset, 
liability,  income,  and  expense  accounts  of  the  business.  The 
customers'  and  stock  and  money  loan  accounts  are  usually 
carried  in  this  ledger  in  total  by  the  use  of  controlling 
accounts. 

Customers  Ledger.  Separate  accounts  are  kept  herein 
for  each  customer,  which  show  not  only  the  customers' 
transactions  and  cash  balance  due  by  or  to  them,  but  also 
the  stocks  "long"  and  "short"  in  their  accounts. 

Stock  Record.  Under  accounts  with  each  security  are 
recorded,  on  the  "long"  side,  the  customers  who  are  "long" 
of  the  securities,  brokers  from  whom  securities  are  bor- 
rowed, or  the  investment  accounts  in  which  are  carried  the 
securities  owned  by  the  brokers ;  and  on  the  "short"  side,  the 
securities  on  hand  (usually  termed  "in  the  box"),  the  cus- 
tomers who  are  "short"  of  the  securities,  the  brokers  to 
whom  securities  are  loaned,  the  banks  or  others  holding 


56o 


AUDITING 


securities  as  collateral  for  loans,  and  the. securities  in  trans- 
fer. The  accounts  with  stocks  are  kept  in  shares,  and 
those  with  bonds  are  kept  in  their  par  value,  and  the  ag- 
gregate of  the  ''long"  and  ''short"  sides  must  agree.  Nu- 
merous vertical  columns  are  provided  for  rebalancing  at 
the  close  of  each  day  those  securities  in  which  transactions 
were  made. 

Margin  Record.  The  status  of  each  customer's  money 
balance  and  the  shares  of  stocks  and  par  of  bonds  as  secur- 
ity for  his  account,  and  the  market  value  thereof,  are  re- 
corded herein,  and  this  information  is  kept  up  to  date  (to 
the  minute)  at  all  times.  It  is  the  indicator  of  weak  mar- 
gins and  is  a  most  important  book.  In  large  offices  it  is 
necessary  to  have  several  such  records.  Margin  clerks 
must  be  alert  and  thoroughly  familiar  with  each  account 
under  their  supervision.  Laxity  or  neglect  in  this  depart- 
ment may  result  in  large  losses  if  the  market  is  active. 

Record  of  Money  Loans.  Entries  are  made  herein  of 
money  loaned  or  borrowed,  and  the  collateral  received  or 
deposited  therefor.  Separate  accounts  are  kept  with  each 
loan,  and  the  aggregate  of  all  the  loans  must  agree  with 
the  controlling  accounts  for  "Money  Loaned"  or  "Money 
Borrowed"  in  the  general  ledger. 

Record  of  Stock  Loans.  For  recording  the  securities 
borrowed  from  or  loaned  to  other  brokers  and  the  amounts 
of  money  deposited  or  received  as  security  for  their  re- 
turn. The  aggregate  of  these  loans  must  agree  with  their 
respective  controlling  accounts  in  the  general  ledger.  Se- 
curities sold  or  bought  ostensibly  for  cash,  but  which  are 
not  delivered  or  received  for  various  reasons  on  the  day 
following  the  transactions,  but  which  non-deliveries  are  not 
intended  to  act  as  "loans,"  are  termed  "Failed  to  Deliver" 
and  "Failed  to  Receive"  items  respectively,  and  are  usually 
covered  by  controlling  accounts  in  the  general  ledger  and 


STOCKBROKERS  561 

the  details  entered  in  a  separate  portion  of  the  record  of 
stock  loans. 

Other  Books.  In  addition  to  the  books  specifically  re- 
ferred to,  there  are  daily  records  of  stocks  in  box,  bank 
pass-books,  cheque  books,  petty  cash  books,  order  books, 
register  of  securities  received  and  delivered,  customers' 
press-copy  books  for  copying  notices  of  purchases  and  sales 
and  customers'  statements,  pay-rolls,  and  other  subsidiary 
expense  and  memorandum  records,    v 

Use  of  Abbreviations 

In  most  brokers'  offices  the  names  of  securities  are  rarely 
written  out  in  full  in  the  books.  The  stock  exchange  ini- 
tials are  generally  used  in  referring  to  listed  securities,  while 
the  names  of  unlisted  stocks  are  abbreviated.  It  is,  there- 
fore, essential  that  the  auditor  be  familiar  with  these  cus- 
tomary abbreviations. 

Program  of  Audit 

A  large  and  competent  staff  should  be  used  on  the  audit 
of  a  broker's  office,  as  the  work  must  be  done  rapidly  and 
accurately.  The  cash  and  revenue  stan^ps  on  hand  must  be 
counted  and  the  balances  checked  with  the  general  ledger 
accounts.  The  securities  on  hand  must  be  examined  and 
scheduled,  or  compared  with  the  box  book,  and  confirma- 
tion forms  prepared  of  all  money  and  securities  borrowed 
and  loaned  and  the  collateral  therefor.  These  forms  should 
be  sent  at  once  to  the  proper  parties,  and  the  aggregate 
of  each  class  of  transactions  proved  with  the  controlling 
accounts  in  the  general  ledger.  Confirmation  forms  should 
also  be  sent  to  the  transfer  offices  of  companies  holding 
securities  for  transfer. 

The  stock  record  should  be  checked  from  the  schedule 
prepared  of  the  securities  on  hand,  and  from  the  duplicates 


c62  AUDITING 

of  the  confirmations  covering  money  and  stocks  loaned  and 
borrowed  and  the  collateral  therefor,  and  of  the  securities 
in  transfer.  The  stocks  **long"  and  "short"  in  customers' 
accounts  should  be  checked  to  the  stock  record  from  the 
statements  to  be  sent  to  the  customers.  The  securities 
"long"  and  "short"  in  the  client's  own  investment  accounts 
may  be  checked  from  the  general  ledger. 

It  is  extremely  important  that  the  stocks  be  balanced 
quickly,  as  in  an  active  market  numerous  changes  are  made 
and  the  investigation  of  differences  is  very  troublesome. 

The  customers'  statements  referred  to  are  copies  of 
their  ledger  accounts,  which  are  usually  written  up  daily  and 
press-copied  at  the  end  of  the  month  and  sent  to  them.  The 
balances  at  the  beginning  of  the  month,  the  transactions 
during  the  month,  and  the  balances  at  the  end  of  the  month, 
as  well  as  the  calculations  of  interest  on  each  transaction, 
are  shown  on  these  statements.  The  securities  received 
and  delivered  and  "long"  and  "short"  at  the  beginning  and 
end  of  the  month  are  also  shown  thereon. 

These  customers'  statements  should  be  press-copied  be- 
fore being  turned  over  to  the  auditor,  who  should  mail 
them,  after  checking  the  stocks  "long"  or  "short"  at  the 
time  of  the  audit,  and  scheduling  the  customers'  names  and 
money  balances  for  checking  with  the  trial  balance  of  the 
customers  ledgers  to  be  verified  later.  When  mailing  them, 
a  form  for  confirming  the  balances  and  securities  in  their 
accounts  at  the  date  of  the  audit  should  be  sent  to  all  cus- 
tomers, as  well  as  return  envelopes,  so  as  to  insure  the  con- 
firmations being  sent  direct  to  the  auditor's  office.  Accounts 
for  which  no  statements  are  sent  should  be  particularly 
investigated  and  called  to  the  client's  attention,  as  they  may 
prove  to  be  "blind"  accounts  which  are  being  used  for 
improper  purposes. 

Accounts  of  the  client  with  other  brokers,  usually  in 


STOCKBROKERS  563 

Other  cities,  are  termed  ''Our  Accounts"  (with  others)  ; 
statements  are  usually  sent  monthly  to  the  client  of  the 
monthly  transactions,  together  with  the  money  balance,  and 
the  stocks  *'long"  and  ''short"  at  the  end  of  the  month. 
These  statements  from  other  brokers  should  be  compared 
with  the  corresponding  accounts  on  the  client's  ledgers,  and 
the  genuineness  of  the  statements  received  should  be  veri- 
fied by  confirming  the  money  balance  and  securities  in  the 
account  by  correspondence. 

The  margins  in  the  customers'  accounts  should  be  care- 
fully scrutinized,  and  accounts  with  weak  or  no  margins 
called  to  the  client's  attention. 

The  bank  accounts  should  be  reconciled  with  the  general 
books  and  the  trial  balances  of  all  ledgers  verified.  No 
nominal  accounts  should  be  kept  in  the  customers  ledger, 
and  all  of  the  accounts  in  the  general  ledger  should  be  care- 
fully scrutinized,  and  such  as  are  not  covered  by  the  work 
usually  done  in  an  audit  of  brokers'  accounts  should  be 
carefully  investigated  and  their  correctness  determined. 

The  correctness  of  the  interest  charged  customers  and 
paid  to  banks  and  brokers,  including  rates  as  well  as  cal- 
culations, and  of  the  commissions  charged  for  executing 
customers'  orders  and  paid  to  floor  brokers  for  executing 
orders,  should  be  thoroughly  tested. 

The  collection  of  income  due  during  the  audit  period 
on  securities  owned  by  the  client  should  be  verified,  and 
all  of  the  charges  to  the  various  expense  accounts  should 
be  carefully  scrutinized,  and  vouchers  and  pay-rolls  ex- 
amined and  compared  with  these  entries. 

The  most  satisfactory  audit  of  brokers'  accounts  is  the 
continuous  audit,  in  which  the  auditor  makes  frequent  visits 
and  detailed  examinations  into  various  departments  of  the 
business  at  different  times,  in  addition  to  verifying  com- 
pletely the  cash,  customers'  accounts,  money  and  stock  loans 


5^4 


AUDITING 


and  collaterals,  and  balancing  the  securities  at  least  twice 
annually. 

Brokers  collect  considerable  sums  in  dividends  for  their 
customers,  a  part  thereof  being  in  turn  paid  to  the  latter, 
but  the  larger  part  credited  to  their  ledger  accounts.  The 
collections  made  are  credited  to  one  or  more  dividend  ac- 
counts. These  accounts  are  debited  with  the  payments  to 
customers  (or  to  other  brokers  who  hold  stock  certificates 
which  still  stand  in  the  name  of  the  broker  who  sold  them 
some  time  before)  and  with  the  amounts  transferred  to 
the  credit  of  customers  whose  accounts  are  ''long"  the  stock 
on  which  the  dividend  has  been  collected.  The  dividend 
account  is  also  credited  with  the  amounts  charged  to  cus- 
tomers who  are  "short"  of  the  stock  on  which  a  dividend 
has  been  paid.  Theoretically  the  nature  of  the  dividend 
account  is  such  that  it  needs  little  or  no  inspection,  but  as 
dividends  are  sometimes  not  called  for  until  long  after  their 
declaration,  it  is  necessary  to  verify  the  entries  in  the  ac- 
count to  make  certain  that  advantage  has  not  been  taken 
of  the  condition  mentioned  to  abstract  dividends  which  may 
not  be  called  for  or  which  should  have  been  credited  to 
some  custorner's  account,  but  on  which  a  "chance  is  taken" 
that  the  customer  will  not  detect  the  failure  to  credit  the 
dividend  to  his  account. 

Instance  of  Fraud 

A  recent  case  of  fraud  discovered  in  a  stockbroker's 
office  was  accomplished  in  the  following  manner : 

The  cashier  was  allowed  to  do  part  of  the  work  on  the 
ledgers.  The  footings  of  the  receipts  entered  in  the  ex- 
clearing  house  blotter  were  reduced  to  the  extent  of  the 
amounts  to  be  taken  or  already  obtained.  Cheques  were 
taken  from  the  back  of  the  cheque  book  and  given  the  same 
numbers  as  current  cheques.    Money  was  obtained  thereon 


BUILDING    AND    LOAN    ASSOCIATIONS 


565 


and  the  cheques  destroyed  when  they  were  returned  by 
the  bank,  when  the  pa^s-book  was  balanced.  No  entry 
was  made  in  the  blotter  for  these  items,  but  the  items  posted 
in  the  ledger  or  the  footings  of  different  accounts  were 
falsified  in  order  to  show  a  correct  trial  balance.  Most  of 
the  erroneous  entries  were  made  in  the  interest  account, 
which,  for  the  most  part,  showed  only  totals  of  the  interest 
for  the  month  as  entered  in  the  different  customers'  ac- 
counts. The  totals  were  ascertained  from  a  detail  sheet, 
which  was  later  destroyed,  and  the  amount  actually  entered 
was  not  in  accordance  with  the  aggregate  of  the  items  for 
the  month.  At  other  times  payments  were  charged  to 
personal  accounts  for  which  no  statements  were  sent  out. 
The  charges  were  sometimes  fictitious  entries  entered  in 
the  ledger  account  only,  or  a  posting  made  from  an  item  in 
the  blotter  which  was  not  covered  by  one  of  the  regular 
cheques. 

Building  and  Loan  Associations 

Building  and  loan  associations  are  usually  organized 
on  the  mutual  plan,  and  the  by-laws  of  most,  if  not  all,  of 
them  call  for  an  annual  audit  of  the  association's  accounts. 
Unfortunately  for  the  stockholders,  however,  this  require- 
ment is  most  frequently  complied  with  by  the  appointment 
of  an  auditing  committee  composed  of  two  or  three  mem- 
bers of  the  board  of  directors,  and,  as  is  usual  in  the  case 
of  amateur  audits,  examinations  made  under  such  circum- 
stances and  by  such  agencies  are  not  always  to  be  relied 
upon.  When  it  is  considered  how  much  power,  as  far  as 
the  finances  and  accounts  are  concerned,  is  exercised  by  one 
man  (usually  the  secretary)  in  these  associations,  it  would 
certainly  pay  them  in  the  end  to  have  the  accounts  periodi- 
cally audited  by  public  accountants. 


566 


AUDITING 


The  fact  that  the  accounts  are  as  a  rule  so  completely 
in  the  hands  of  one  person  renders  it  obligatory  on  the 
auditor  to  make  a  thorough  and  detailed  examination.  In 
an  audit  under  such  circumstances,  tests  of  the  work  are 
not  usually  sufficient.  The  audit  fees  are  generally  small 
but  this  must  not  limit  the  scope  of  the  work. 

The  audit  of  a  building  and  loan  association  differs  from 
that  of  most  financial  institutions  in  that  it  has  to  deal  with 
an  organization  the  capital  stock  of  which  is  not  fixed  in 
amount,  and  that  the  borrowers  are,  for  the  most  part,  stock- 
holders as  well,  and  both  interest  and  principal  of  the  loans 
are  paid  in  small  instalments,  such  payments  being  made 
either  monthly  or  weekly  at  the  same  time  that  dues,  i.e., 
payments  on  account  of  capital  stock,  are  paid. 

The  capital  stock  consists  of  a  number  of  series,  a  new 
series  being  started  each  year,  each  six  months,  or  in  some 
few  cases  even  as  often  as  every  three  months.  A  fixed 
amount,  usually  $1,  though  sometimes  50  cents  or  25  cents 
(the  latter  very  infrequently),  is  paid,  say,  monthly,  on 
each  share  of  stock  held,  and  when  these  periodical  con- 
tributions, together  with  the  accrued  profits,  reach  a  specified 
amount,  say  $200,  the  series  of  stock  is  paid  off.  In  this 
way  there  is  a  constant  contributing  and  withdrawing  of 
capital  going  on,  one  or  more  new  series  of  stock  being 
started  each  year,  and  one  or  more  series  maturing  in  each 
year.  In  addition  to  matured  stock,  withdrawals  are  made 
by  the  stockholders  who  for  one  reason  or  another  cannot 
or  do  not  care  to  continue  until  the  maturity  of  their  series. 
In  the  case  of  such  withdrawals  a  penalty  is  imposed  by 
paying  somewhat  less  than  the  full  amount  of  the  profits 
accrued  on  the  stock.  In  a  well-managed  association,  the 
by-laws  of  which  call  for  monthly  payments  of  $1  per  share 
and  fix  the  full  value  of  a  share  at  $200,  a  series  usually 
matures  about  eleven  or  twelve  years  after  its  inception. 


BUILDING    AND    LOAN    ASSOCIATIONS  567 

By-Laws  and  Minute  Books 

The  auditor  should  examine  closely  the  by-laws  to  make 
himself  familiar  with  the  requirements  of  the  association. 
He  should  also  be  familiar  with  the  regulations  imposed 
by  the  state. 

He  should  make  an  examination  of  the  minutes  for  the 
period  under  review  to  see  that  the  resolutions  adopted  by 
the  directors  are  in  accordance  with  the  state  laws  and  the 
by-laws  and  that  they  have  been  given  effect  in  the  records 
wherever  necessary. 

Verification  of  Income 

The  dues  paid  in  by  members  are  not,  of  course,  income 
or  earnings.  They  are  contributions  of  capital,  and  a  very 
careful  accounting  thereof  is  essential.  By  ascertaining 
the  total  shares  outstanding  in  each  series  at  the  beginning 
of  the  year,  and  allowing  for  withdrawals  during  the  year 
(after  the  year  in  which  a  series  has  its  inception  no  addi- 
tional shares  can  be  issued),  the  receipts  from  dues  can  be 
proven  as  a  whole. 

The  interest  on  loans  will  need  to  be  carefully  verified. 
Much  of  the  interest  is  paid  in  monthly  instalments,  and 
as  many  of  the  loans  are  made  on  a  6  per  cent  basis,  the 
interest  can  be  quickly  verified.  In  connection  with  loans 
to  stockholders,  the  item  of  premiums  must  not  be  over- 
looked. The  by-laws  of  many  associations  provide  for  what 
practically  amounts  to  competitive  bidding  by  the  stock- 
holders for  the  funds  in  the  treasury.  When  the  applica- 
tions for  loans  exceed  the  available  funds,  a  premium  is  paid 
by  the  successful  applicants.  The  granting  of  these  loans 
should  be  recorded  in  the  minutes,  and  the  premiums  to 
be  accounted  for  should  be  ascertainable  from  this  source. 

Fines  on  delinquent  dues  and  interest  are  other  items 
of  income.     They  are  usually  fixed  at  a  high  rate,  e.g.,  2 


^68  AUDITING 

per  cent  per  month,  to  compel  promptness  in  making  pay- 
ments, but  do  not  usually  form  a  large  item  of  income. 

In  the  case  of  associations  which  charge  admission  fees 
(usually  25  cents  per  share),  these  are  readily  verified  in 
total  on  the  total  number  of  shares  in  the  new  series  issued 
during  the  year. 

Building  and  loan  associations  do  not  invest  in  real  estate 
except  when  compelled  to  buy  it  in  to  protect  an  investment 
in  a  mortgage  loan  which  is  foreclosed.  When  real  estate 
is  owned,  the  income  therefrorrj  should  be  verified.  A 
comparison  of  the  net  income  with  the  book  value  of  the 
properties  should  be  made  so  as  to  be  sure  that  real  estate 
is  not  being  carried  at  excessive  figures. 

The  best  verification  of  the  dues  and  interest  appearing 
as  unpaid  on  the  books  is  to  publish  a  list  of  the  account 
numbers  and  amounts  of  such  arrearages  in  the  associa- 
tion's published  annual  statement.  A  good  verification  of 
the  capital  stock  outstanding  would  be  for  the  auditor  to 
be  present  at  the  meeting  next  following  the  commence- 
ment of  the  audit  and  to  examine  each  stockholder's  pass- 
book as  it  is  presented  at  the  time  of  paying  dues.  The 
numbering  of  all  stockholders'  accounts  and  the  consecutive 
numbering  of  the  pass-books  by  the  printer,  all  pass-books 
to  be  accounted  for,  is  also  a  safeguard. 

Expenses 

These  are  verified  in  the  usual  manner.  To  the  credit 
of  these  associations  it  must  be  said  that  most  of  them  are 
economically  conducted  and  the  direct  outlays  for  salaries, 
etc.,  are  seldom  excessive. 

Inspection  of  Securities 

A  very  important  feature  of  the  audit  is  naturally  the 
examination  of  the  securities  owned.    Mortgages,  insurance 


BUILDING    AND    LOAN    ASSOCIATIONS  569 

policies,  and  other  documents  pertaining  to  real  estate  loans, 
assigned  capital  stock  certificates,  notes  for  loans  on  stock 
collateral,  and  real  estate  deeds,  are  all  to  be  carefully 
scrutinized. 

Distribution  of  Profits 

An  important  part  of  the  audit  is  the  verification  of 
the  annual  statement.  Most  associations  pubUsh,  in  addi- 
tion to  a  balance  sheet,  a  statement  of  cash  receipts  and  pay- 
ments, and  not  the  Profit  and  Loss  account,  although  it 
is  on  the  basis  of  the  results  shown  by  the  latter  that  the 
apportionment  of  profits  among  the  various  series  of  stock 
is  made.  There  are  several  plans  of  profit  distribution  in 
use,  not  all  of  equal  merit. 

The  most  equitable  and  accurate  plan  is  to  treat  as  the 
capital  for  the  year  the  dues  paid  in  and  the  profits  accrued 
thereon  up  to  the  beginning  of  the  fiscal  year  under  re- 
view, plus  the  equivalent  sum  for  one  year  of  the  instal- 
ments paid  in  during  the  year,  and  less  the  entire  dues  paid 
in  and  the  accrued  profits  to  the  beginning  of  the  fiscal 
year  on  stock  withdrawn  during  the  year.  On  the  average 
working  capital  for  the  year  so  determined,  the  percentage 
of  the  year's  earnings  as  shown  by  the  balance  of  the  Profit 
and  Loss  account  is  ascertained.  The  calculation  of  the 
average  working  capital  is  made  by  separate  series  as  well 
as  in  total,  and  the  percentage  earned  added  to  each  series. 
The  total  earnings  for  the  year  are  thus  apportioned  among 
the  various  series.  The  accrued  profits  in  excess  of  the 
amounts  actually  paid  to  withdrawing  stockholders  are  in- 
cluded as  a  part  of  the  year's  earnings. 

A  plan  which  is  in  use  by  many  associations,  but  which 
is  misleading,  in  that  the  apparent  percentage  of  earnings 
to  capital  is  higher  than  is  actually  the  case,  is  that  by 
which  accrued  profits  are  not  treated  as  a  part  of  the  capi- 


c^o  AUDITING 

tal,  the  profits  being  calculated  and  apportioned  simply  on 
the  basis  of  the  dues  paid  in.  As  this  constitutes  a  smaller 
amount  on  which  to  calculate  the  percentage  which  the 
earnings  are  of  the  capital  stock,  the  apparent  rate  of  earn- 
ings is  higher  than  the  actual  rate. 

Some  associations  even  go  so  far  as  to  reapportion  each 
year  all  the  profit  earned,  not  only  in  the  current  year,  but 
in  preceding  years,  on  all  unmatured  series  of  stock.  This 
is  clearly  wrong  and  inequitable.  Each  year,  which  usually 
marks  the  entrance  of  a  new  series  of  stockholders,  should 
witness  the  apportionment  of  its  earnings  in  accordance  with 
the  actual  earnings,  which  apportionment  should  remain 
undisturbed  in  the  remaining  years  which  the  various  series 
have  yet  to  run. 

It  should  be  stated,  however,  that  in  many  cases  the 
by-laws  of  the  association  prescribe  the  basis  on  which 
profits  shall  be  apportioned  among  the  various  series,  and 
in  such  an  event  the  auditor  cannot  do  otherwise  than 
comply  with  them.  In  such  cases  it  would  seem  desirable 
to  call  the  attention  of  the  directors  to  the  desirability  of 
adopting  the  most  accurate  method. 

Most  associations  publish  balance  sheets,  statements  of 
receipts  and  payments,  profit  and  loss,  and  capital  stock, 
more  or  less  like  the  forms  shown  on  pages  571  and  572. 

A  few  associations  publish  statements  of  capital  stock 
showing  the  dues  paid  in  and  the  profits  earned  in  each 
year  on  each  series  of  stock  outstanding.  This  makes  a 
very  complete  and  informing  exhibit  of  an  association's 
experience  for  a  period  of  years. 

Being  chartered  by  the  state,  building  and  loan  associa- 
tions are  usually  subject  to  the  supervision  of  the  state 
banking  department.  The  forms  of  report  required  vary 
in  different  states.  Those  given  here  have  been  selected  and 
adapted  from  the  best  ones  in  use. 


BUILDING    AND    LOAN    ASSOCIATIONS 


571 


ON 


C  t*  «  I. 
O  C  3  o 


«  a 


■5Q 


H 
Ui 

u 
<: 

< 


H 
Q 


u 

w 


W 


(4     . 



—  1) 

215 

.  u    .    .   • 

3 

=u 

CIS 

c^f,  • 

•s  •  •  • 

^2 

.ss    . 

w  i  « 

CO  3 

•«0"X 

•S-« 

S--5H 

i?  . 

•:::«•§• 

si . 

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Et^2  . 

WW 

w  S!  C"     • 

i5 

y-H^-O 

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rt««C/2 

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J 

OJOQCMU 

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C  0^2  rt  «  W  O  3 


.  a 


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g"    .1°  .   cS'S 

«  2  ,«  J^-2  «»«»«« 


572 


AUDITING 

Statement  of  Capital  Stock 

19 


Shares 

Value   per  Share 

Value 

of 
Series 

With- 
drawal 
Value 

Series 
No. 

Date  of 
Issue 

Bor- 
rowed on 

Free 

Total 

Dues 

Profits 

Total 

Sha're 

$ 

$ 

$ 

$ 

$ 

$....* 

*This  amount   should   agree  with   the   item   of   "Capital   Stock"   shown   in   the 
balance  sheet. 


Profit  and  Loss  Account 
Year  Ended 191 

Earnings 

Interest $ 

Premiums 

Fines  

Admission  and  Transfer  Fees 

Rents  of  Real  Estate $ 

Less — Insurance,  Taxes,  etc 

Profits  on  Stock  Withdrawals 

Expenses 

Interest  on  Stock  Withdrawn $ 

Interest  on  Borrowed  Money 

Administration  Expenses 

Net  Profit  for  Apportionment  Among  Stock  Series..     $. 


CHAPTER    XXiy 

SPECIAL   POINTS   IN   DIFFERENT  CLASSES   OF 
AUDITS    (Continued) 


INSURANCE 

In  almost  all  states  insurance  companies  cannot  organ- 
ize under  the  general  corporation  laws,  but  must  incorporate 
under  special  laws.  These  laws  usually  provide  inter  alia 
that  the  companies  shall  be  subject  to  inspection  by  the  in- 
surance commissioner  of  the  state.  Furthermore,  such  ex- 
aminations are  not  limited  to  the  state  in  which  a  company 
is  incorporated,  but  it  is  subject  to  examination  by  the  in- 
surance commissioner  of  every  state  in  which  it  is  registered 
to  do  business. 

The  examinations  made  by  state  insurance  commis- 
sioners are  similar  in  purpose  to  examinations  of  banking 
institutions  made  by  the  national  and  state  governments. 
The  chief  ends  sought  in  these  examinations  are  to  ascer- 
tain whether  or  not  the  company  is  solvent  and  to  prevent 
any  violation  of  the  insurance  laws.  While  these  are  most 
important  objects — even  pre-eminently  so — they  by  no 
means  embrace  all  the  duties  of  the  professional  auditor. 

As  is  to  be  expected,  the  state  examinations  vary  con- 
siderably as  to  the  efficiency  with  which  they  are  conducted. 
It  is  not  to  be  wondered  at  if  the  staff  of  a  department, 
whose  members  may  have  been  recruited  largely  through 
the  medium  of  political  appointments,  does  not  possess  tech- 
nical ability  or  experience  of  a  very  high  order.  In  this 
connection  it  may  also  be  mentioned  that  the  abuses  which 

573 


2^4  AUDITING 

were  revealed  by  the  investigation  of  a  number  of  the  large 
New  York  life  insurance  companies,  had  been  going  on  for 
years  in  spite  of  the  fact  that  the  companies  were  supposed 
to  be  periodically  examined  by  the  New  York  Insurance 
Department,  and  were  reporting  regularly  to  that  Depart- 
ment. It  is  a  significant  fact  that  in  recent  years  quite 
a  number  of  the  large  life  insurance  companies  have 
adopted  the  plan  of  having  their  accounts  audited  by  public 
accountants. 

Fire  Insurance  Companies 

Naturally  the  auditor  will  need  to  inform  himself  as  to 
the  meaning  of  various  technical  terms  and  expressions. 
Aside  from  this,  the  audit  of  a  fire  insurance  company  will 
offer  no  serious  difficulty,  as  the  accounts  are  not  very 
complicated. 

Premiums  form  the  largest  item'  of  income.  The  initial 
record  of  the  premium  income  appears  in  the  agents'  re- 
ports. Enough  of  these  should  be  traced  into  the  books 
to  satisfy  the  auditor  of  the  correctness  of  the  books  in 
this  respect. 

Balances  due  from  agents  at  the  close  of  the  fiscal  period 
should  be  thoroughly  verified.  This  may  be  done  by  analyz- 
ing the  agents'  accounts  and  taking  up  with  some  one  in 
authority  such  balances  as  are  in  arrears.  The  balances 
should  also  be  verified  by  comparison  with  the  closing  bal- 
ance on  the  agent's  last  monthly  statement. 

Income  from  investments  is  another  considerable  item; 
this  can  and  should  be  completely  verified.  The  securities 
themselves  must  also  be  examined ;  this  will  be  done  in  the 
same  manner  as  in  the  case  of  banks  or  other  financial 
institutions. 

Unless  the  audit  is  specifically  limited  to  the  verification 
of  the  balance  sheet,  the  payments  for  losses  and  expenses 


INSURANCE  575 

will  need  to  be  vouched.  The  vouchers  for  losses  paid, 
expenses,  and  other  items  of  outgo,  should  be  properly  ap- 
proved. Insurance  policies  on  which  losses  have  been  paid 
should  be  traced  into  the  premium  income  record  to  see 
that  the  company  actually  received  a  consideration  for  the 
risk  on  which  payment  was  made  to  the  insured.  Irregu- 
larities in  the  accounting  for  premiums  may  perchance  be 
brought  to  light  by  this  plan.  In  connection  with  losses, 
steps  should  also  be  taken  to  see  that  collection  has  been 
made  for  such  part  of  the  loss  as  had  been  reinsured.  The 
system  of  recording  reinsurances  should  be  such  as  to  in- 
sure the  collection  of  the  pro  rata  part  of  losses  payable 
by  other  companies.  Credits  to  agents  for  return  premiums, 
rebates,  and  commissions  should  also  receive  attention. 

The  importance  of  safeguarding  the  payments  for  pre- 
mium refunds  and  rebates  from  the  standpoint  of  estab- 
lishing an  effective  internal  check,  as  well  as  the  importance 
of  the  professional  auditor's  covering  the  matter  thoroughly, 
is  forcibly  brought  out  by  the  following  extract  from  a 
newspaper  account  of  the  embezzlement  of  $13,000  in  a 
little  over  three  years  by  two  clerks  who  asserted  that  they 
were  not  in  collusion,  but  who  were  both  "operating"  at 
the  same  time  in  the  New  York  office  of  a  large  British 
fire  insurance  company: 

Walker  and  Bradford,  as  their  depositions  state,  were  employed  in 
the  auditing  department  of  the  insurance  company.  .  .  .  Their  method 
of  obtaining  money  was  to  cause  cheques  to  be  issued  which  appeared 
to  be  in  payment  of  premium  rebates  on  canceled  policies.  Both 
Walker  and  Bradford  prepared  these  cheques  in  the  regular  course  of 
their  day's  work  and  presented  them  to  the  cashier  for  his  signature. 
Then  they  were  supposed  to  be  sent  to  persons  who  had  canceled 
policies.  The  accountants  discovered  that  no  account  was  taken  of 
the  cheques  thus  issued  and  that  the  returned  vouchers  were  never 
examined. 

Bradford  said  the  idea  of  drawing  cheques  to  fictitious  persons,  or 
of  duplicating  cheques  already  issued  and  then  forging  the  indorse- 


576 


AUDITING 


ments,  came  to  him  through  the  suggestions  of  a  fellow  employee,  who, 
however,  had  no  idea  of  operating  it  himself. 

"I  went  broke  one  night,"  says  Bradford  in  substance  in  his  deposi- 
tion. "I  think  I  had  been  shooting  craps  in  Dey  Street.  At  any  rate, 
the  family  were  all  away.  I  had  sent  my  wife  to  the  country,  and 
there  was  no  one  at  home.  I  was  at  my  wits'  end  to  raise  money  the 
next  day. 

"I  went  out  to  lunch  with  a  fellow  employee  and  in  the  course  of 
the  meal  he  suggested  how  easy  it  would  be  to  raise  money  by  dupli- 
cating cheques  sent  to  policyholders  who  were  withdrawing,  or  even 
by  sending  cheques  to  purely  fictitious  persons.  The  fact  of  the  send- 
ing of  a  cheque  was  entered  in  a  register,  but  when  the  cheque  was 
returned  from  the  bank  it  was  never  examined  beyond  seeing  if  it  bore 
the  proper  indorsement.  It  was  never  compared  with  the  policy  which 
occasioned  its  issuance,  and  so  the  company  never  knew  whether  a 
rebated  premium  had  been  paid  more  than  once  or  not.  That  started 
me  thinking. 

'T  didn't  have  to  make  a  study  of  it.  It  came  just  as  naturally  as 
taking  a  drink.  The  cheques  all  went  through.  I  got  various  persons 
to  cash  them,  and  the  company  always  paid  without  question.  By  this 
time  I  had  got  to  the  point  of  drawing  cheques  for  any  name  at  all  and 
then  indorsing  them  properly.  Then  it  occurred  to  me  once  that  if  an 
investigation  were  made  of  the,  register  it  would  be  found  that  the 
name  of  the  person  who  actually  had  received  the  proper  cheque  for 
his  rebate  wouldn't  agree  with  the  indorsement  on  my  cheque,  which 
corresponded  in  number  to  the  good  cheque,  always  supposing  that  it 
was  my  cheque  which  chanced  to  be  looked  up.  I  never  felt  in  any 
fear  of  their  finding  both  cheques. 

"To  cover  myself  I  began  erasing  names  from  the  register  and 
substituting  the  names  for  which  I  had  made  out  my  cheques.  These 
erasures  finally  attracted  the  attention  of  the  auditors,  but  they  couldn't 
catch  onto  the  scheme  then  until  I  told  them  how  it  was  worked." 

Walker  stumbled  on  the  plan  because  he  happened  to  notice  once 
that  in  eight  years  only  one  thorough  examination  of  the  canceled 
policies  and  payments  of  rebated  premiums  was  made  by  the  auditors 
of  the  company.  As  soon  as  he  found  how  easily  the  scheme  worked, 
he  began  to  pay  his  bills  with  cheques  drawn  on  the  insurance  company. 

He  bought  a  piano  with  one  of  his  early  cheques,  making  the 
cheque  payable  to  the  piano  salesman  from  whom  he  made  his  pur- 
chase. In  the  insurance  company's  office,  had  anyone  looked  it  up, 
it  would  have  appeared  that  this  salesman  was  receiving  a  rebated 
premium  on  a  canceled  policy.  To  the  salesman  himself  it  appeared 
merely  that  Walker  had  asked  his  employer  to  make  out  a  cheque  for 
his  convenience. 


INSURANCE 


577 


Walker  said  he  paid  his  rent  regularly  each  month  with  one  of  the 
company's  cheques,  making  it  out  in  favor  of  his  landlord.  Walker 
said  that  while  Bradford  never  suspected  him,  he  had  known  for  six 
months  before  their  arrest  that  Bradford  was  doing  the  same  thing, 
but  said  he  never  had  spoken  to  him  about  it  until  they  met  in  police 
headquarters  as  prisoners. 

Most  of  the  cheques  which  Bradford  and  Walker  drew  were  for 
amounts  less  than  $50,  so  that  it  required  more  than  200  falsified 
cheques  for  them  to  obtain  the  $13,208. 

Liabilities 

By  far  the  largest,  as  well  as  the  most  important,  item 
among  the  liabilities  is  the  reinsurance  reserve.  The  basis 
on  which  this  must  be  calculated  is  usually  fixed  by  state 
law.  The  plan  most  generally  followed  is  to  reserve  one- 
half  of  the  gross  premiums  (net  of  reinsurance)  on  all 
unexpired  one-year  policies  and  pro  rata  parts  of  the  gross 
premiums  on  unexpired  policies  written  for  a  longer  term 
than  one  year,  allowance  being  made  for  the  full  number 
of  years  of  the  term  which  have  already  expired.  The 
deposits  reclaimable  by  the  assured  are  taken  as  the  lia- 
bility on  perpetual  policies. 

The  liabilities  should  include  full  provision  for  losses 
adjusted,  but  not  yet  paid,  and  for  all  unadjusted  or  dis- 
puted losses.  Unpaid  expenses,  accrued  taxes,  etc.,  should 
also  be  allowed  for  in  stating  the  liabilities. 

Life  Insurance  Companies 

In  many  respects  the  audit  of  a  life  insurance  company 
will  follow  the  same  lines  as  the  audit  of  a  fire  insurance 
company.  There  are,  however,  some  points  of  difference, 
as  will  presently  be  seen. 

The  investments  of  even  a  moderate-sized  life  company 
will  be  found  to  be  very  numerous,  and  their  examination 
will  require  considerable  time  and  care.  In  addition  to  veri- 
fying the  fact  of  their  being  in  the  possession  of  the  com- 


578 


AUDITING 


pany  or  deposited  with  properly  constituted  authorities,  such 
as  the  state  insurance  departments  (when  the  latter  is  the 
case,  the  fact  should  be  verified  by  correspondence),  the 
income  which  should  have  been  received  from  the  invest- 
ments is  to  be  verified. 

The  auditor  will  do  well  to  inform  himself  as  to  what 
securities  are  legal  investments  under  the  laws  of  the  state 
in  which  the  company  is  incorporated.  The  valuation  of 
the  investments  is  of  great  importance. 

According  to  a  statement  issued  by  the  Superintendent 
of  Insurance  of  New  York,  the  valuation  of  securities  of 
insurance  companies  to  be  given  in  their  reports  to  the 
Superintendent  as  of  January  1,  1915,  were  to  be  based 
on  the  prices  as  of  June  30,  1914  instead  of  December  31 
as  theretofore.  This  change  was  made  on  the  assumption 
that  the  prices  for  December  31  were  not  available,  the 
securities  markets  of  the  country  being  closed  on  account 
of  the  European  war.  June  30,  1914  was  the  date  selected, 
as  it  was  thought  this  represented  a  more  nearly  normal 
market  than  July  30,  1914.  If  the  prices  for  July  30  were 
used,  the  insurance  companies  would  have  been  compelled 
to  enter  their  investments  at  a  considerable  loss.  And 
should  valuations  be  fixed  on  the  market  prices  December 
31,  1914,  such  prices  would  have  resulted,  it  was 
thought,  in  a  serious  depletion  in  the  surpluses  of  all  the 
companies,  with  the  possibility  of  the  weaker  concerns 
having  this  item  wiped  out  entirely. 

The  following  is  the  statement  issued  by  the  New  York 
State  Superintendent  of  Insurance : 

Each  year  the  National  Convention  of  Insurance  Commissioners 
of  the  United  States  issues  a  pamphlet  containing  the  value  of  securi- 
ties as  of  December  31.  The  values  in  this  pamphlet  are  used  in  audit- 
ing statements  of  insurance  companies  in  their  reports  to  the  Super- 
intendents   of    Insurance.      Owing   to    the   financial    conditions    which 


INSURANCE 


579 


result  from  the  European  war  and  the  consequent  closing  of  the  stock 
market,  it  will  be  impracticable  this  year  to  obtain  valuations  as  of 
December  31,  1914.  In  order  that  a  date  satisfactory  to  the  Super- 
intendents of  Insurance  throughout  the  country  could  be  decided  upon, 
Frank  Hasbrouck,  Chairman  of  the  Committee  on  Valuation  of  Securi- 
ties of  the  National  Convention  of  Insurance  Commissioners,  com- 
municated with  the  Committee  on  Valuation  and  requested  them  to 
state  the  date  which  they  favored  should  be  used  as  a  basis  for 
valuing  securities.  Of  the  replies  received  seven  of  the  Committee 
were  in  favor  of  June  30,  1914,  one  favored  waiting  until  December  1 
to  make  a  decision,  and  one  favored  July  30,  1914. 

As  a  large  majority  favored  June  30,  1914,  it  was  decided  that 
quotations  of  that  date  should  be  used  this  year  as  a  basis  for 
valuations  by  insurance  companies.  In  1907,  when  a  condition  some- 
what similar  to  the  present  one  occurred  in  the  financial  market,  the 
insurance  companies  used  the  so-called  average  of  13  in  arriving  at  a 
value  for  securities — that  is,  a  price  for  each  security  for  a  certain 
day  in  each  month  for  twelve  months — and  the  last  day  of  the  preced- 
ing year  was  obtained  and  the  total  divided  by  13,  which  gave  the 
average  price  then  used.  This  system  was  not  altogether  satisfactory, 
so  that  this  year  it  has  been  decided  to  use  a  specific  date — that  of 
June  30,  1914. 

Conditions  prevailing  on  June  30  were  such  that  the  prices  then 
obtainable  represented  normal,  conditions.  Immediately  thereafter 
rumors  of  war  and  the  declaration  of  war  were  responsible  for  a 
marked  decline  in  the  value  of  securities,  and  it  would  be  unfair  to 
penalize  our  insurance  companies  for  a  condition  that  is  only  temporary. 
There  is  no  doubt  at  all  but  that  the  intrinsic  value  of  securities  held 
by  insurance  companies  has  remained  unchanged  and  that  the  decline 
in  price  will  be  only  temporary. 

Loans  to  policyholders  secured  by  an  assignment  of  the 
policies  now  form  an  item  of  considerable  size  in  the  assets 
of  most  large  companies.  Inasmuch  as  the  loan  never  ex- 
ceeds the  amount  of  the  reserve  accumulated  on  the  policy, 
such  loans  are  a  very  good  asset.  The  notes  and  assigned 
policies  should  be  examined  as  a  means  of  verifying  the 
policy  loans. 

The  laws  of  most  states  prohibit  insurance  companies 
from  investing  in  real  estate  except  for  their  own  use. 
These  laws  have,  however,  been  interpreted  as  permitting 


58o  AUDITING 

the  ownership  of  large  office  buildings,  of  which  a  com- 
pany may  use  but  a  small  part  for  itself.  The  companies 
must  also  buy  in  real  estate  occasionally  to  protect  their 
investments  in  mortgages.  Consequently,  real  estate  may 
form  another  asset  of  considerable  amount.  This  necessi- 
tates a  verification  of  the  income  from  rentals.  Receipts 
from  sales  of  real  estate  should  also  receive  attention,  as 
it  is  usually  the  aim  to  dispose  of  foreclosed  property  as 
soon  as  it  can  be  done  without  loss.  The  valuations  at 
which  the  real  estate  appears  in  the  balance  sheet  should 
be  supported  by  independent  appraisals. 

The  insurance  reserve  of  life  insurance  companies  is 
calculated  on  an  entirely  different  basis  from  that  of  a  fire 
insurance  company.  The  calculations  are  made  by  the 
company's  actuary,  and  the  auditor  is  not  ordinarily  ex- 
pected to  do  more  than  see  that  the  reserve  as  stated  in 
the  balance  sheet  agrees  with  the  actuary's  figures.  Some- 
times, however,  the  auditor  is  instructed  to  make  a  test  of 
the  actuary's  calculations.  In  such  instances  it  may  be 
desirable  for  him  to  engage  the  services  of  an  actuary  to 
do  this  work.  On  the  other  hand,  the  accountant  who  has 
a  good  grasp  of  the  underlying  principles  of  life  insurance 
can,  himself,  by  the  use  of  tables  which  are  prepared  for 
the  purpose,  test  the  calculations  of  the  reserve  and  satisfy 
himself  that  it  has  been  properly  summarized,  and  that  it 
includes  reserves  for  all  classes  of  outstanding  policies  which 
require  them. 

It  is  rather  surprising  that,  with  the  magnitude  which 
the  insurance  business  has  attained,  the  companies  are,  or 
at  least  until  recently  were,  content  to  put  up  with  the 
primitive  accounting  systems  in  use  by  most  companies. 
This  may  have  been  due  in  part  to  the  fact  that  the  forms 
of  reports  prescribed  by  state  insurance  departments  en- 
couraged unscientific  accounting  methods.    While  the  forms 


INSURANCE 


581 


of  report  have  been  somewhat  improved  in  recent  years, 
they  still  leave  much  to  be  desired. 

A  few  years  ago  a  committee  of  the  American  Associa- 
tion of  Public  Accountants,  acting  jointly  with  a  committee 
•  of  the  New  York  State  Society  of  Certified  Public  Ac- 
countants, appeared  before  the  Armstrong  Committee  of 
the  New  York  Legislature.  In  addition  to  forcefully  pre- 
senting the  necessity  for  reform  in  insurance  accounting 
methods  (see  the  April,  1906,  Journal  of  Accountancy  for 
a  report  of  the  committee's  criticisms  and  suggestions),  the 
committee  submitted  a  number  of  model  forms,  which  are 
reproduced  on  pages  582  to  586. 

It  is  a  matter  of  regret  that  the  insurance  authorities 
did  not  see  fit  to  adopt  the  forms.  They  would  have  been 
a  great  improvement  over  the  present  forms.  They  give 
in  a  concise  manner  the  information  which  is  of  value  to 
the  policy  or  stock  holder,  and  by  means  of  supplementary 
schedules  they  can  be  amplified  as  much  as  may  be  desired. 

The  model  forms,  while  designed  primarily  for  life  com- 
panies, could  easily  be  adapted  to  the  needs  of  fire  and 
other  insurance  companies. 


582 


AUDITING 


The  Ideal  Life 
Balance  Sheet — 


Assets 

Real  Estate— (Appraised  Value)  : 
Office  Buildings : 

Home  Office $ 

Domestic   Branches 

Foreign  Branches $. 

Other  Real  Estate _^ 

Secured  Loans : 

On  Mortgage $. 

On  Policies 

On  Other  Collateral _. 

Bonds,   Stocks  and  Other  Marketable  Se- 
curities—  (Market  Value)  : 
Bonds : 
Government,    State,   and   Municipal  of 

the  United  States  and  Canada $ 

Railroad    and    Traction    Companies    in 

the  United  States  and  Canada 

Foreign — Held  Chiefly  to  Comply  with 

Statutory  Requirements 

Miscellaneous  $. 

Stocks : 

Railroad    and    Traction    Companies    in 

the  United  States  and  Canada $ 

Financial  and  Insurance  Companies  in 

the  United  States  and  Canada 

Miscellaneous  

Syndicate   Subscriptions 

Cash: 

In  Banks  and  Trust  Companies : 

Home  Office,  Subject  to  Cheque $ 

Branches    and    Agencies,    Subject    to 

Cheque  

On  Deposit  on  Special  Terms $, 

Deposits  with  Foreign  Governments.  / 

In  Transit 

On  Hand — At  Home  Office,  Branches  and  Agencies 
Premiums  in  Course  of  Collection  or  Collected  and 
not  Reported : 

First  Year  Premiums $. 

Renewal  Premiums 

Annuities 

Agents'  Balances  and  Miscellaneous  Advances 

Interest  and  Rentals  Due  or  Accrued : 
Interest : 

On  Bonds  and  Dividends  on  Stocks. . .     $ 

On  Secured  Loans 

On  Agents'  Advances  and  Balances 

Miscellaneous $. 

Rentals 


p 


INSURANCE 

Insurance  Company 
December  31,  19.  . . 

Liabilities 

General  Insurance  Reserve : 

(, Describing  Basis) $. 

Current  Liabilities : 
Under  Policies  and  Policy  Contracts : 

Death  Claims — Due  and  Unpaid $ 

Matured  Endowments 

Annuities — Due  and  Unpaid 

Dividends — Due  and  Unpaid $ 


583 


Commissions  and  Current  Expenses : 
Commissions  on   Premiums   in   Course 

of  Collection $. 

Current  Expenses 


Premiums,  Interest  and  Rents  Prepaid,  and  Sundry  Deposits 

Capital   Stock 

Surplus  and  Reserves : 

Contingency  Fund $ 

Investment   Fluctuation   Reserve  Fund 

Deferred    Dividend    Funds 

Annual  Dividend   Funds 

Unappropriated  Surplus 


584 


AUDITING 


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INSURANCE  587 

Casualty,  Health,  Surety,  Title  Guarantee,  and  Other 
Companies 

In  the  main,  the  accounts  of  these  companies  will  be 
similar  to  those  of  fire  companies.  The  most  important 
difference  is  that  the  basis  of  determining  the  reinsurance 
reserve  is  not  always  the  same  as  for  fire  companies.  For 
instance,  it  is  customary  to  include  the  full  amount  of  the 
gross  premiums  on  unexpired  risks  in  the  reserve  of  marine 
and  inland  navigation  companies.  Health  companies  re- 
semble life  companies  somewhat  and  their  reserve  may  be 
based  on  actuarial  principles. 

Insurance  Companies  and  the  Income  Tax 

In  auditing  the  accounts  of  an  insurance  company  the 
question  of  the  correct  amount  to  pay  under  the  federal 
income  tax  law  will  probably  arise.  The  auditor  should 
consult  the  decisions,  etc.,  relating  thereto  in  the  Appendix 
to  this  book.  In  addition,  special  rulings  applicable  to  in- 
surance companies  are  available  and  should  be  referred  to. 

MANUFACTURING 

The  accounts  of  manufacturers  are  submitted  to  the 
auditor  probably  as  often  as  any  one  other  class  of  accounts. 
Consequently  he  should  be  well  informed  on  such  matters 
as  are  especially  pertinent  to  manufacturing  accounts. 

Expenditures  for  wages  should  be  thoroughly  verified. 
It  is  well  for  the  auditor  to  be  present  at  the  paying  off 
of  a  roll  so  that  he  may  observe  the  methods  used ;  in  fact, 
he  should  follow  the  system  of  handling  the  pay-roll  through, 
from  the  initial  steps  in  making  it  up  to  the  final  paying 
out  of  the  wages  to  the  workmen. 


588 


AUDITING 


The  system  of  receiving  materials  and  checking  the  in- 
voices therefor,  both  as  to  quantity  and  quahty,  should 
also  be  made  the  subject  of  careful  observation.  An  espe- 
cially important  matter  is  to  see  that  freights  which  are 
chargeable  to  shippers  are  duly  deducted  from  the  pay- 
ments for  purchases.  Similarly,  the  freights  on  outgoing 
shipments  should  be  examined  to  make  certain  that  none 
which  are  prepayments  on  sales  made  f.  o.  b.  factory,  and 
which  are  consequently  chargeable  to  customers,  have  been 
absorbed  in  the  manufacturing  expense  accounts. 

Depreciation  of  plant  is  an  item  which,  while  not  peculiar 
to  manufacturing  industries,  is  of  especial  importance  in 
that  connection.  The  basis  on  which  the  allowances  there- 
for are  made  varies  in  different  industries.  For  textile 
mills,  machine  shops,  etc.,  it  is  customary  to  base  the  de- 
preciation allowances  on  percentages  of  the  plant  values, 
the  percentages  being  in  turn  based  on  the  estimated  useful 
life  of  the  plant  or  different  parts  thereof.  In  industries 
like  blast  furnaces  and  coke  works  the  allowance  is  fre- 
quently based  on  a  certain  rate  per  unit  of  production,  the 
amount  of  the  allowance  for  different  fiscal  periods  varying 
in  direct  proportion  to  the  fluctuation  in  the  output  of  pig 
iron  or  coke  respectively.  A  legitimate  reason  for  such  a 
basis  is  that  in  industries  such  as  those  named,  a  very  large 
output  imposes  a  correspondingly  heavy  strain  on  the  plant, 
whereas  when  the  production  is  light,  the  wear  and  tear 
on  furnace  and  oven  linings,  etc.,  is  much  less. 

Miscellaneous  income  needs  to  be  carefully  looked  for 
and  verified.  One  such  item  which  is  quite  frequently  en- 
countered is  the  income  from  houses  owned  by  manufac- 
turers who  are  located  at  a  distance  from  cities  and  towns, 
and  who  rent  these  houses  to  their  employees.  Most  fre- 
quently, though  not  invariably,  the  rents  are  deducted  from 
wages  payable  to  the  employee  tenants. 


MANUFACTURING  589 

As  often  as  not,  the  record  of  rents  is  in  crude  form. 
A  suitable  form  of  rent  roll  should  be  suggested.  The 
record  should  be  based  on  the  rents  accruing,  not  merely  on 
the  collections  when  made. 

In  stating  the  operations  of  the  undertaking,  the  taxes, 
repairs,  and  other  expenses  which  can  be  allocated  to  the 
houses  owned  should  be  applied  against  the  rents  (though 
preferably  showing  the  gross  of  both  rents  and  expenses), 
and  the  net  income  or  expense  extended. 

When  the  buildings  used  for  manufacturing  are  leased 
and  a  portion  of  the  space  is  sublet,  it  is  desirable  that  both 
the  gross  amount  of  rent  paid  and  the  amount  received  for 
the  space  sublet  be  shown  so  that  any  fluctuations  in  the 
net  amount  of  rent  paid  which  are  due  to  the  sublet  premises 
becoming  vacant  may  carry  their  own  explanation  with 
them. 

A  comprehensive  system  of  cost  and  stock  accounts  is 
very  desirable.  In  the  absence  of  such  a  system  the  in- 
ventory valuations  contain  an  element  of  guesswork  and  the 
auditor  cannot  be  certain  that  they  represent  actual  manu- 
facturing cost.  Correct  cost  and  stock  accounts  are  also 
of  vital  importance  for  the  aid  which  they  give  in  carry- 
ing on  the  manufacturing  operations  to  the  best  advantage. 


590 


AUDITING 


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AUDITING 


In  those  industries  in  which  there  is  but  a  single  unit 
of  production — such  as  tons,  pounds,  barrels,  or  gallons — 
at  least  the  sales  accounts  should  be  kept  not  only  as  to 
values,  but  also  in  quantities.  Under  such  conditions  it 
will  occasionally  be  possible  to  lay  out  the  accounts  on  the 
general  books  in  such  a  manner  as  to  show  therein  the  aver- 
age manufacturing  cost  per  unit  of  production.  Keeping 
cumulative  records  of  quantities  in  connection  with  the 
values,  not  only  of  sales,  but  also  of  materials  purchased 
and  used,  will  enable  the  auditor  to  make  a  comparison  of 
the  quantity  of  materials  used  with  the  resulting  quantity 
of  finished  product,  and  ascertain  whether  the  ratio  of  one 
to  the  other  is  within  a  reasonable  range  of  the  average 
experienced  in  the  particular  industry. 

Uniformity  of  detail  in  the  financial  statements  of  manu- 
facturing concerns  is  not  to  be  expected.  It  will  doubtless 
be  of  interest  to  students,  however,  to  see  forms  of  state- 
ments which  are  actually  in  use.  On  page  590  is  shown 
the  general  form  of  balance  sheet  which  is  used  by  quite  a 
number  of  American  manufacturing  corporations,  following 
which  is  the  form  prescribed  by  the  English  Companies  Act. 

Publishers  of  Books 

Publishers  who  do  not  do  their  own  printing  and  bind- 
ing are  in  the  position  of  merchants  who  have  goods  manu- 
factured for  them  according  to  their  special  pattern  and 
design.  Those  who,  in  addition,  have  their  own  printing- 
plants  are  both  manufacturers  and  merchants.  In  practi- 
cally all  cases,  even  if  there  is  not  a  retail  store  connected 
with  the  business,  there  is  a  department  for  filling  retail  mail 
orders. 

There  are  several  considerations  more  or  less  special  to 
publishers'  accounts,  and  reference  will  be  made  to  these. 
Royalties  paid  to  authors,  while  not  exclusively  found  in 


PUBLISHERS  593 

publishers'  accounts,  are  in  point  of  proportion  a  more  im- 
portant item  here  than  in  most  businesses.  Royalty  ac- 
counts with  authors  should  be  carefully  checked.  The  credits 
thereto  should  be  thoroughly  tested  to  see  that  they  are 
for  quantities  actually  sold  and  that  the  rate  per  copy  is  in 
accordance  with  the  contract  between  publisher  and  author. 
Sometimes  the  contract  will  be  on  a  profit-sharing  basis, 
and  in  such  cases  the  auditor  will  need  to  satisfy  himself 
that  all  costs  have  been  taken  into  account. 

Advance  payments  on  account  of  royalty  should  not  be 
included  among  the  accounts  receivable  from  customers, 
but  should  be  set  out  separately  in  the  balance  sheet.  The 
matter  of  royalties  also  raises  an  important  question  re- 
garding the  valuation  of  unsold  books  at  inventory  dates. 
If  authors  are  credited  with  royalties  only  as  their  works 
are  actually  sold,  care  should  be  taken  to  see  that  the  cost 
of  production  at  which  the  books  in  the  inventory  are  valued 
does  not  include  the  item  of  royalty.  Of  course,  if  authors 
are  credited  with  royalties  as  books  are  bound,  even  though 
they  are  not  yet  sold  (there  are  some  publishers  who  pur- 
sue this  plan,  though  they  are  in  the  minority),  it  is  quite 
proper  to  value  the  books  at  a  figure  which  includes  the 
royalty. 

Another  very  important  question  in  connection  with  the 
valuation  of  sheet  stock  and  bound  books  is  that  of  sala- 
bility.  Cost  is  far  too  high  a  valuation  of  books  for  which 
the  demand  has  died  out,  or  for  which  there  may  never 
have  been  a  demand. 

The  best  way  to  determine  the  strength  of  the  demand 
for  books  of  which  large  quantities  are  on  hand,  is  to  ascer- 
tain the  number  sold  during  the  last  fiscal  period.  The  ratio 
of  the  quantity  on  hand  to  the  quantity  sold  will  furnish 
data  for  determining  whether  or  not  the  stock  should 
be  valued  at  full  cost  or  only  a  fraction  thereof,  or,  if  quite 


594 


AUDITING 


unsalable,  at  the  price  of  waste  paper.  Even  in  applying 
this  test,  however,  care  must  be  taken  not  to  be  misled  by 
large  sales  early  in  the  period  which  may  have  dwindled 
away  in  the  latter  part  of  the  period;  the  facts  in  such  a 
case  probably  being  that  the  demand  has  died  out. 

Still  another  consideration  in  connection  with  inventories 
— and  this  affects  accounts  receivable  as  well — is  to  see  that 
the  latter  do  not  include  consigned  stock  in  agents'  hands. 
Such  stock  should  appear  in  the  inventory  at  cost  or  less 
and  not  among  the  accounts  receivable  at  selling  prices. 

Such  stock  on  hand  as  paper,  ink,  binding  materials,  and 
other  supplies,  presents  no  unusual  problems.  With  regard 
to  the  quantities  of  stock,  books  are  an  article  of  which  the 
auditor  can  readily  verify  the  quantities  stated  in  the  in- 
ventory by  making  an  actual  count.  It  is  very  desirable  to 
make  some  such  tests,  especially  of  the  larger  quantities. 

The  overvaluing  of  artists'  drawings  (for  illustrations), 
if  indeed  any  value  whatever  is  to  be  allowed  for  them,  must 
be  guarded  against.  Such  values  are  sometimes  based  on 
sentiment  rather  than  on  what  would  be  realized  if  the 
articles  were  sold. 

Whether  or  not  the  values  placed  on  the  book  plates  are 
reasonable,  demands  careful  inquiry  on  the  part  of  the 
auditor.  "Circumstances  alter  cases,"  and  this  adage  is 
true  of  book  plates  as  well  as  of  other  things.  Obviously, 
it  would  be  quite  proper  to  carry  the  plates  of  an  edition  of 
the  Encyclopedia  Britannica  or  of  some  standard  scientific 
work  at  a  considerable  part  of  their  cost  long  after  the 
entire  cost  of  the  plates  for  a  more  ephemeral  piece  of  litera- 
ture, like  a  novel,  should  have  been  written  off  in  toto.  The 
plates  for  a  novel  should  be  written  off  entirely  as  a  part  of 
the  cost  of  the  first  edition — there  may  never  be  another; 
the  great  majority  of  novels  do  not  run  through  more  than 
one.     As  already  indicated,  the  plates  of  a  work  which  will 


PUBLISHERS 


595 


be  standard  for  a  number  of  years  may  be  written  off  more 
gradually,  particularly  as  the  greater  initial  cost  frequently 
includes  large  expenditures  for  contributions  and  editorial 
work  which  take  the  place  of  royalties  payable  over  a  period. 

The  fact  that  the  effective  demand  for  such  a  work  is 
realized  over  a  long  period  of  time  is  another  justification 
for  charging  off  the  cost  of  such  plates  more  gradually. 

At  the  same  time,  the  world  moves  so  rapidly  and  new 
discoveries  are  so  frequent  that  works  which  are  standard 
today  are  out-of-date  tomorrow,  and  an  issue  of  an  encyclo- 
pedia or  other  reference  work  is  not  authoritative  for  as 
long  a  period  as  was  formerly  the  case. 

Some  large  failures  in  the  publishing  business  are  trace- 
able to  the  omission  to  charge  against  the  cost  of  books  a 
proper  proportion  of  the  cost  of  plates.  In  view  of  the 
large  profits  which  were  apparently  being  earned,  liberal 
amounts  of  cash  were  withdrawn  from  the  business.  The 
actual  facts  were  that  the  liquid  assets  or  working  capital 
of  the  business  were  being  replaced  by  a  growing  fictitious 
investment  in  plates  and  copyrights.  The  only  safe  plan  is 
to  charge  off  liberally. 

As  a  parting  word  on  the  subject  it  may  be  said  that  the 
value  of  plates  and  copyrights  should  never  be  increased 
above  cost.  Even  though  there  is  every  indication  that  the 
demand  for  certain  publications  will  continue,  or  even  in- 
crease, and  result  in  large  profits  in  the  future,  that  is  no 
reason  for  anticipating  such  profits  and  capitalizing  them 
by  raising  the  book  value  of  the  plates,  and  correspondingly 
crediting  current  income  or  even  surplus  account. 

Accounts  receivable  require  especially  close  scrutiny  in  a 
publishing  business.  One  pitfall  has  already  been  referred 
to,  viz.,  that  accounts  will  frequently  be  found  among  the 
receivables  which  are  in  reality  consignment  accounts. 
Where  books  are  sold  on  the  instalment  plan,  the  balances 


596 


AUDITING 


on  such  accounts  also  require  careful  examination.  The 
right  to  reclaim  such  books  if  they  are  not  paid  for  in  full, 
does  not  put  the  accounts  in  the  secured  class,  as  it  usually 
costs  about  as  much  to  recover  books  sold  on  the  instal- 
ment plan  as  they  are  worth. 

An  especially  liberal  reserve  for  losses  on  instalment 
accounts  should  be  made,  as  there  is  a  large  margin  of 
profit  in  instalment  sales  to  offset  the  losses  which  may  con- 
fidently be  expected.  The  condition  of  the  other  customers' 
accounts  as  to  promptness  of  payment  will  naturally  be  an 
important  element  in  the  determination  of  how  large  the 
reserve  for  possible  losses  thereon  should  be. 

Large  amounts  of  postage  are  used  in  a  publishing  busi- 
ness. A  record  of  the  purchases  of  stamps  and  of  the  quanti- 
ties issued  for  use  on  requisitions  of  the  shipping,  advertis- 
ing, correspondence,  and  other  departments,  should  be  kept 
as  a  means  of  preventing  abuses  which  may  otherwise  occur. 

There  are  quite  a  few  sources  of  miscellaneous  receipts 
in  the  publishing  business,  particularly  in  the  printing  end, 
such  as  waste  print  paper,  cuttings,  ink  barrels,  boxes,  gilt 
sweepings,  etc.  So  far  as  possible  all  such  items  should  be 
carefully  accounted  for. 

Publishers  of  Magazines  and  Newspapers 

These  accounts  present  some  problems  quite  different 
from  those  of  book  publishers'  accounts.  Finished  stock  is 
usually  a  minor  item,  consisting  of  back  numbers  and  bound 
volumes  of  magazines.  Past  issues  of  newspapers  are  never 
given  any  value  in  the  inventory  other  than  as  waste  paper. 

Plates  also  are  not  a  vital  factor.  Their  value  should  be 
limited  strictly  to  that  of  the  metal  as  such,  excepting  per- 
haps the  small  amount  of  plates  for  advertisements  under 
long  contracts  and  similar  standing  matter,  on  which  a 
somewhat  higher  value  may  be  placed. 


PUBLISHERS  597 

When  the  estate  of  Joseph  Pulitzer,  former  owner  of 
the  Nezv  York  World  and  St.  Louis  Post-Dispatch,  was 
being  valued  for  the  inheritance  tax,  experts  gave  their 
opinions  on  this  question  as  follows : 

Melville  E.  Stone,  general  manager  of  the  Associated 
Press,  and  several  others,  testified  that  in  their  opinion  the 
properties  should  be  valued  on  the  basis  of  the  capitaliza- 
tion of  the  average  earnings  over  a  period  of  years  at  15 
per  cent.  Others  thought  that  17j/^  per  cent  would  be  more 
nearly  correct,  while  the  surrogate  representing  the  State  of 
New  York  thought  10  per  cent  was  fair. 

Two  of  the  most  important  items  which  are  peculiar  to 
magazines  and  newspapers  are  the  revenues  derived  from 
advertising  and  "circulation"  respectively.  A  century  ago, 
newspapers  may  have  been  published  on  the  basis  of  the 
income  from  subscriptions  furnishing  the  bulk  of  the  where- 
withal to  pay  the  cost  of  publication,  but  that  day  has  past 
long  since,  and  the  same  thing  may  be  said  of  magazines. 
Ordinarily,  the  subscription  or  circulation  revenue  does  not 
cover  the  cost  of  production  and  distribution,  and  the  only 
inducement  to  extend  the  circulation  is  because  of  the  higher 
rates  for  advertising  space  which  the  larger  circulation 
commands. 

In  the  case  of  a  monthly  magazine,  all  the  advertisements 
in  several  numbers  out  of  the  year's  issues  should  be  com- 
pared with  the  charges  for  advertising  recorded  in  the  books. 
Proper  authority  should  be  shown  for  such  advertisements 
as  have  been  inserted  without  charge.  Some  of  the  contracts 
should  also  be  consulted  for  the  purpose  of  testing  the 
correctness  of  the  rates  charged.  If  the  accounts  of  a  news- 
paper are  being  audited,  the  charges  for  the  advertisement 
in  one  or  two  days'  issues  of  each  month  should  be  verified. 
More  difficulty  is  likely  to  be  encountered  in  verifying  the 
revenue  from  classified  advertising  than  in  verifying  the 


598 


AUDITING 


income  from  display  advertising,  particularly  if  the  system 
of  recording  the  classified  advertisements  is  of  the  happy- 
go-lucky  kind  which  not  infrequently  obtains.  The  im- 
portance of  examining  the  commission  accounts  of  advertis- 
ing agents  and  solicitors  should  not  be  overlooked. 

Subscription  income  is  difficult  to  verify.  On  account  of 
the  immense  volume  of  detail  it  is  out  of  the  question  to 
check  it  with  any  approach  to  completeness.  The  best  that 
can  be  done,  in  addition  to  making  tests  of  the  clerical  work, 
is  to  assure  oneself  that  the  system  is  the  best  that  can  be 
devised  to  safeguard  the  integrity  of  the  subscription,  or — 
as  it  is  usually  termed  in  the  case  of  newspapers — cash  cir- 
culation, and  to  compare  the  total  circulation  revenue  with 
the  approximate  amount  which  it  would  seem  that  the  num- 
ber of  copies  printed,  after  making  due  allowance  for  unsold 
and  returned  copies,  should  have  yielded. 

Data  for  making  the  latter  test  will  be  obtained  from 
the  press-run  record,  the  circulation  manager's  statement 
of  the  disposition  of  the  number  of  copies  printed  (sold, 
exchanged,  returned,  distributed  free,  etc.),  and  the  news 
agency's  reports.  That  part  of  a  magazine's  circulation 
which  goes  directly  to  subscribers  by  mail  may  be  approxi- 
mately verified  by  dividing  the  weight  per  copy  (including 
wrapper)  into  the  total  weight  shown  by  the  post-office 
receipts  for  second-class  postage  paid.  This  must  be  done 
separately  for  each  issue,  as  the  number  of  pages  will 
probably  vary  from  one  issue  to  another,  and  this  will  in 
turn  change  the  weight  per  copy.  Knowing  the  circulation 
of  a  magazine,  some  idea  can  be  formed  of  the  approximate 
amount  of  subscription  revenue  which  should  have  been 
received. 

Precautions  should  also  be  taken  to  prevent  abuses  of 
the  free  list.  Names  should  be  entered  thereon  only  with 
the  approval  of  some  one  in  authority. 


PUBLISHERS 


599 


While  on  the  subject  of  verifying  circulation,  it  may 
not  be  amiss  to  refer  to  so-called  ''circulation  audits"  which 
are  at  times  made  on  behalf  of  advertisers'  associations  or 
directly  for  newspapers  which  desire  to  substantiate  their 
claims  of  having  a  certain  circulation. 

There  are  a  number  of  ways  of  manipulating  newspaper 
circulation  records  which  can  be  detected  only  by  an  audit 
of  the  general  accounts.  For  example,  the  cash  sales  (office 
sales  and  mail  subscriptions)  may  be  inflated,  making  them, 
say  $100  or  $200  or  more,  larger  than  the  amount  actually 
collected,  and  then  charging  off  the  inflated  amount  monthly, 
quarterly,  or  at  irregular  intervals,  to  some  expense  account, 
no  details  accompanying  the  entry  therefor  in  the  general 
cash  book.  Another  method  which  has  been  used  is  to  over- 
charge news  agents'  accounts,  or  to  charge  to  fictitious 
agents  papers  which  were  never  actually  delivered.  Event- 
ually such  charges,  which  served  the  purpose  of  inflating  the 
circulation  earnings  when  they  were  made,  are  written  off 
as  bad  debts  or  to  some  expense  account  (really  an  offset 
against  the  circulation  earnings  account  and  frequently  so 
treated  in  preparing  the  confidential  statements  for  the 
management).  In  the  circulation  accounts  receivable  ledger 
these  credits  may  be  entered  as  cash  instead  of  as  allowances 
or  as  bad  debts  written  off. 

From  the  foregoing  it  is  obvious  that  a  circulation  audit 
which  is  restricted  to  an  examination  of  the  circulation 
records,  and  during  which  the  auditor  does  not  have  access 
to  the  general  books,  is  absolutely  worthless.  It  proves 
nothing  except,  perhaps,  that  the  circulation  records  may 
have  been  very  cleverly  manipulated.  A  verification  of  the 
revenue  purporting  to  have  accrued  from  circulation  can 
be  conclusive  only  when  the  disposition  of  the  cash  repre- 
sented to  have  been  received  is  traced  and  the  outstanding 
accounts  receivable  are  satisfactorily  verified.    Other  means, 


6oo  AUDITING 

or  rather  partial  means,  of  verifying  the  circulation  are 
the  press-run  book,  which  is  a  record  of  the  number  of 
papers  indicated  by  the  automatic  counters  on  the  presses  to 
have  been  printed,  and  the  quantity  of  paper  used,  the  latter 
being  ascertained  by  referring  to  the  purchase  invoices  and 
applying  the  quantity  of  paper  on  hand  at  the  beginning 
and  end  of  the  period.  The  auditor  must,  of  course,  take 
steps  to  assure  himself  that  the  press-run  book  which  is 
submitted  to  him  has  not  been  "faked"  for  his  especial 
benefit.  From  either  of  these  sources  only  the  gross  circula- 
tion printed  is  obtained.  It  will  still  be  necessary  to  ascer- 
tain the  number  of  copies  spoiled,  unsold,  returned,  sent  to 
exchanges,  etc.,  and  deduct  the  total  thereof  from  the  num- 
ber printed,  before  the  net  paid  circulation  can  be  determined. 
The  Subscription  Earnings  account  of  a  magazine 
should  include  only  that  part  of  the  subscriptions  received 
which  has  actually  been  earned  during  the  period.  That 
portion  of  subscriptions  received  previous  to  the  period 
under  review,  but  which  has  been  earned  during  the  period, 
should,  of  course,  also  be  included  therein.  The  unexpired 
pro  rata  of  subscriptions  in  force  at  the  close  of  the  period 
should  appear  in  an  Unearned  Subscriptions  account  and  be 
entered  among  the  liabilities  in  the  balance  sheet  as  unearned 
or  deferred  income.  There  are  several  methods  for  de- 
termining the  actual  subscription  earnings  of  the  period  and 
the  unexpired  amount  at  the  end  of  the  period.  Under  either 
plan  the  subscription  receipts  are  credited  to  an  account 
termed,  say,  "Unearned  Subscriptions,"  and  periodically, 
usually  monthly,  the  amount  earned  during  the  period  is 
transferred  to  a  "Subscription  Earnings"  account.  One 
way  of  determining  the  amount  of  the  monthly  earnings  is 
to  classify  the  subscription  receipts  according  to  expiration 
dates,  from  which  the  actual  earnings  for  a  given  month  can 
readily  be  determined.     Another  way  is  to  ascertain  the 


PUBLISHERS  60 1 

average  annual  realization  per  subscription  and  then 
multiply  the  number  of  copies  mailed  by  one-twelfth  of  the 
average  annual  rate.  While  the  second  plan  can  be  safely 
followed  if  the  data  used  in  making  the  calculations  is  care- 
fully verified,  the  first  mentioned  plan  is,  perhaps,  less  liable 
to  give  rise  to  inaccuracies. 

With  many  newspapers  the  ajinual  or  semiannual  sub- 
scriptions form  such  a  small  part  of  the  total  circulation 
that  a  reserve  for  unexpired  subscriptions  is  almost  or  quite 
unnecessary.  Others  again  have  a  very  large  mailing  list 
of  individual  subscribers,  and  in  such  cases  a  reserve  for 
unexpired  subscriptions  should,  of  course,  be  created. 

A  reserve  for  returns  should  also  be  made  in  the  case 
of  both  magazines  and  newspapers.  A  very  few  of  the 
magazines  do  not  permit  agents  to  return  unsold  copies,  but 
the  great  majority  do.  Almost  all  newspapers  accept  from 
newsboys  unsold  copies  of  the  previous  day's  issue  in  ex- 
change for  the  current  day's  papers.  In  the  case  of  regular 
news  agents,  credit  is  allowed  in  the  monthly  settlement  for 
copies  charged,  but  not  sold  by  the  agents.  The  reserve 
should  be  based  on  past  experience  as  to  the  ratio  of  returns 
to  gross  circulation,  and  if  set  up  only  at  the  end  of  the  fiscal 
period,  will  be  determined  by  applying  the  percentage  de- 
cided upon  to  the  circulation  accounts  receivable. 

Not  all  magazine  publishers  print  the  magazines  them- 
selves. The  printing  and  mailing  is  sometimes  done  by 
contract,  the  publisher  supplying  the  paper,  which  he  buys 
direct  to  eliminate  the  printer's  profits  thereon.  Frequently, 
however,  a  newspaper  publisher  will  have  his  own  printing 
plant.  The  accounts  pertaining  to  this  end  of  the  business 
will  naturally  call  for  much  the  same  general  treatment  as 
those  of  other  printers. 

Publishers  who  have  their  own  printing  plant  frequently 
do  job  printing.    Even  if  there  is  not  a  regular  job  depart- 


6o2 


AUDITING 


merit,  special  work  like  circulars  of  newspaper-sheet  size 
may  occasionally  be  run  off.  This,  as  well  as  other  sources 
of  miscellaneous  receipts,  which  are  often  quite  numerous, 
should  not  be  overlooked. 

Magazine  and  book  publishing  is  very  frequently  com- 
bined in  one  business,  but  this  fact  of  itself  does  not  intro- 
duce any  complications  except  in  the  apportionment  of  gen- 
eral charges.  The  magazine  and  book  departments  will 
ordinarily  be  found  to  be  quite  distinct. 

Breweries 

In  breweries  there  is  probably  a  greater  opportunity  for 
theft  of  supplies  or  product  and  misapplication  of  collections 
than  in  almost  any  other  business.  The  containers — boxes, 
bottles,  kegs,  and  barrels — are  never  sold,  but  remain  the 
property  of  the  brewer.  The  value  of  these  should  not  be 
set  up  in  the  balance  sheet  as  accounts  receivable  if  they  are 
charged  against  customers.  This  is  sometimes  done.  It  is 
easily  seen  that  the  loss  in  such  stock  is  considerable,  and 
that  the  value  set  upon  it  should  be  investigated  carefully. 
The  auditor  should  see  that  adequate  accounting  methods 
are  in  force,  not  only  for  the  containers,  but  for  all  other 
stock,  and,  if  not,  report  should  be  made  thereon. 

The  fact  that  collections  are  frequently  made  by  the 
drivers  is  a  weak  point,  requiring  special  attention  and 
necessitating  close  scrutiny  of  all  allowances  and  discounts. 

Usually  a  large  amount  of  money  is  invested  in  saloons, 
either  owned  or  controlled  by  reason  of  loans  made.  Fre- 
quently the  brewery  pays  for  the  license  and  collects  on  same 
from  the  saloon-keeper  in  monthly  instalments.  The  auditor 
should  see  that  the  income  from  these  sources  is  properly 
taken  up,  and  at  the  same  time  see  that  adequate  provision 
is  made  for  bad  and  doubtful  accounts,  as  the  loss  on  these 
advances  is  considerable  and  is  looked  upon  as  being  an 


MINING 


603 


expense  of  keeping  the  product  before  the  public.  In  addi- 
tion to  amounts  actually  loaned  to  customers,  the  brewery 
frequently  guarantees  loans  made  to  customers  by  others. 
Such  guarantees  constitute  a  large  contingent  liability  and 
should  be  set  up  as  such  in  a  balance  sheet  or  indicated  in 
a  footnote. 

MINING 

Coal  Mines 

A  practitioner  engaged  to  audit  the  accounts  of  a  mining 
enterprise  for  the  first  time  will  do  well  to  make  an  inspec- 
tion of  the  entire  mine  workings  and  equipment,  accom- 
panied by  the  client's  engineer  or  mine  superintendent. 
Careful  observation  will  give  him  some  idea  of  the  condi- 
tion of  the  equipment  and  scope  of  the  undertaking,  which 
should  be  of  assistance  to  him  when  auditing  the  books  and 
preparing  the  financial  statements. 

As  the  largest  source  of  income  is  from  the  sale  of  coal, 
the  inventories  and  the  sales  tonnages  should  be  proved  with 
the  production  records.  Deductions  from  miners'  wages  for 
"blacksmithing"  (dressing  their  tools)  are  frequently  made 
on  the  basis  of  production;  when  so,  the  collection  of  this 
income  can  be  verified  in  total.  Arrangements  are  usually 
made  with  companies  operating  general  stores  at  the  mines 
(unless  the  mining  company  operates  its  own  store,  which 
will,  in  that  case,  be  audited  separately)  to  allow  the  miners 
to  make  purchases  on  credit,  the  amounts  due  therefor  being 
deducted  from  the  wages  of  the  mining  company's  em- 
ployees. Commissions  on  these  collections  are  generally 
charged  by  the  mining  companies.  The  collection  of  rents 
from  houses  occupied  by  employees  and  owned  by  the  min- 
ing company  should  also  be  checked. 

Some  coal  companies  own  railroad  cars,  for  the  use  of 


6o4 


AUDITING 


which  income  should  be  received  from  the  railroad  com- 
panies on  a  mileage  basis. 

The  matter  of  royalties  on  coal  mined  from  leased 
lands  requires  careful  attention.  They  are  based  upon  ton- 
nage of  production  or  cubic  yards  or  acreage  o'  the  seams 
worked,  and  the  royalty  agreements  usually  provide  for  a 
minimum  annual  payment,  in  the  event  of  the  production 
being  so  small  that  the  regular  royalty  rate  would  not 
require  payments  equal  to  the  fixed  minimum. 

In  the  case  of  comparatively  new  mines  the  minimum 
royalties  will  usually  be  paid  during  the  sinking  of  shafts 
and  period  of  development  work.  If  the  lease  agreement 
allows  a  lessee  to  recoup  himself  subsequently  for  the 
proportion  of  the  minimum  royalty  paid  in  excess  of  the 
amount  earned  (calculated  on  a  tonnage  basis),  such  ex- 
cess is  usually  carried  among  the  assets  as  a  deferred 
charge.  As  the  production  increases  to  a  point  beyond 
that  at  which  the  royalty,  calculated  on  a  tonnage  basis, 
equals  the  fixed  minimum,  and  the  lessee  begins  to  recoup 
himself  for  the  advance  royalties,  the  amounts  of  such 
retained  royalties  should  be  applied  in  reduction  of  the  de- 
ferred charge  above  mentioned. 

It  is  important  that  all  royalty  agreements  be  carefully 
examined,  and  if  they  do  not  provide  that  the  lessee  may 
recoup  himself  for  advance  royalties,  the  latter  should  be 
charged  against  revenue.  It  sometimes  occurs,  where  a 
mine  is  being  operated  under  several  leases,  that  only  a 
portion  of  the  leased  lands  are  being  mined,  and  that  por- 
tions thereof  will  never  be  worked.  Obviously,  any  mini- 
mum royalties  paid  under  terms  of  leases  covering  lands 
in  that  class  should  not  be  carried  as  deferred  charges, 
and  for  that  reason  the  Advance  Royalties  account  should 
be  carefully  analyzed  and  such  charges  eliminated  if  in- 
cluded therein. 


MINING 


605 


If  a  time  limit  is  set  in  which  the  lessee  must  recoup 
himself  for  advance  royalties,  any  portion  still  carried  as  a 
deferred  charge  at  the  time  the  limit  expires  should  be  at 
once  charged  off. 

All  lands,  plants,  and  equipment  accounts  should  be 
scrutinized,  and  only  such  charges  should  be  included  as 
represent  the  cost  of  lands  which  add  to  the  area  of  coal 
available  for  future  mining,  or  which  cover  expenditures 
for  development,  construction,  and  equipment  which  will 
result  in  increased  production. 

Provision  should  be  made  for  reduction  of  equipment, 
development,  and  construction  accounts  to  the  amount  of 
the  residual  value  of  the  machinery  included  therein  by 
the  time  the  mines  are  exhausted.  This  is  usually  done 
by  charging  mining  costs  at  a  certain  rate  per  ton  of  pro- 
duction. The  depreciation  of  railroad  cars,  if  any  are 
owned,  and  of  live  stock,  should  not  be  taken  care  of  on 
such  a  basis,  however,  but  on  the  basis  of  probable  length 
of  service. 

While  it  is  desirable  to  provide  for  depreciation  in  value 
of  lands  by  reason  of  the  depletion  of  the  coal  thereunder, 
it  is  not  certain  that  mining  companies  are  legally  required 
to  replace  such  wasting  capital  by  reserving  any  portion 
of  their  earnings  therefor.  In  instances  where  this  is  not 
done,  the  auditor  can  only  call  attention  to  the  advisability 
of  such  a  course,  which,  when  followed,  is  usually  based 
on  the  number  of  tons  produced.  The  following  extract 
from  a  paper  prepared  by  A.  Lowes  Dickinson,  C.P.A., 
and  read  at  the  St.  Louis  Congress  of  Accountants  in  1904, 
is  of  interest  in  this  connection : 

In  the  case  of  minerals,  the  product  taken  out  of  the  land  becomes 
the  stock-in-trade  of  a  corporation  as  soon  as  it  is  extracted,  and 
whatever  the  land  was  worth  before  its  extraction,  it  is  clearly  worth 
an  appreciable  amount  less  thereafter.    The  provision  to  be  made  should 


6o6  AUDITING 

be  on  the  basis  of  the  number  of  tons  extracted,  having  regard  to  the 
total  tonnage  available  and  to  the  realizable  value  of  the  property  after 
the  minerals  have  all  been  extracted.  The  same  principle  would  also 
apply  to  timber  lands  where  no  provision  is  made  for  reforesting.  The 
contention  is  sometimes  made  that  no  provision  need  be  made  for 
exhaustion  of  minerals  where  the  amount  of  mineral  known  to  be  in 
a  definite  tract  at  the  end  of  any  period  is  largely  in  excess  of  that 
which  had  been  discovered  at  the  beginning  of  the  period.  This  argu- 
ment cannot,  however,  for  a  moment  be  admitted,  except  as  a  reason 
for  reducing  the  tonnage  rate  to  be  provided.  As  a  general  principle, 
whatever  there  was  in  the  land,  whether  known  or  unknown,  has  been 
reduced  during  the  period  under  consideration  by  whatever  amount 
has  been  extracted;  and  while  the  new  discoveries  may  be  accepted 
as  reducing  the  necessary  rate  of  provision  for  extinction  from,  say, 
one  dollar  to  one  cent  per  ton,  the  original  principle  that  provision 
must  be  made  holds  good  on  the  smaller  figure,  whatever  it  is.  It 
may  be,  of  course,  that  the  provisions  made  in  earlier  years  have  been 
sufficient  to  cover  a  number  of  future  years  on  the  basis,  from  the 
commencement,  of  the  rate  subsequently  found  to  be  sufficient  in  view 
of  the  new  discoveries,  and  in  this  case  there  is  obviously  no  necessity 
to  provide  further  for  extinction  until  the  total  production  at  the  new 
rate  is  equal  to  the  total  amount  written  off. 

Mortgages  upon  coal  and  ore  lands  usually  provide 
for  the  establishment  of  a  sinking  fund  from  which  to 
pay  off  the  mortgage,  either  in  instalments  or  in  full  on  a 
specified  date.  The  auditor  should  read  carefully  all  the 
mortgages  of  the  property  of  his  client  and  call  attention  to 
any  unpaid  sinking  fund  charges.  The  trustee  cannot 
always  be  depended  upon  to  collect  the  instalments. 

Some  mortgages  require  payments  to  be  made  into  the 
sinking  funds  on  the  basis  of  the  entire  tonnage  mined 
(which  would  include  all  coal  consumed  in  the  company's 
operations),  while  others  base  the  charge  only  on  commer- 
cial production,  which  would  be  only  that  actually  sold. 

The  cash  held  by  trustees  of  sinking  funds  is  to  be 
used  for  retiring  mortgage  obligations  only,  and  therefore 
should  be  shown  separately  on  the  balance  sheet  and  not 
mingled  with  current  cash  accounts. 


MINING  5o7 

Gold  Mines 

Accountants  are  often  engaged  by  committees  of  dis- 
satisfied creditors  or  stockholders  to  investigate  the  disposi- 
tion of  the  cash  capital  invested  in  gold,  silver,  copper,  and 
other  mining  enterprises.  In  instances  where  the  ore  is 
found  in  profitable  quantities,  the  auditor  should  not  feel 
compelled  to  accept  the  periodical  cash,  production,  and 
shipping  statements  received  from  the  mine  office,  unless 
accompanied  by  original  vouchers,  ore  records,  assay  re- 
ports, and  shipping  data. 

Not  only  should  the  shipping  memoranda  be  compared 
with  the  sales  reports,  the  vouchers  for  expenditures  at  the 
mines  compared  with  the  cash  statements,  and  all  of  the 
mine  reports  carefully  checked  and  compared  with  the  gen- 
eral books,  but  every  effort  should  be  made  to  account  for 
the  entire  production.  Where  the  product  is  sent  to  out- 
side smelters  for  reduction,  tests  should  be  made,  using  the 
client's  assay  reports  of  values  shipped  as  a  basis,  to  ascer- 
tain that  the  smelter  returns  are  correct. 

The  correctness  of  the  distribution  of  expenditures  be- 
tween capital  and  operating  accounts  should  be  certified 
to  by  the  mine  manager.  He  should  be  requested  to  furnish 
a  certificate  setting  forth  in  detail  the  local  current  assets 
and  liabilities  or  the  fact  that  none  exist. 

A  report  from  the  mine  manager  upon  the  efficiency 
of  the  plant  and  equipment,  and  upon  the  age  and  condi- 
tion of  the  buildings  and  other  more  or  less  permanent 
local  assets,  is  necessary  in  order  to  consider  properly  the 
question  of  depreciation  which  should  be  allowed  for  in 
the  accounts. 

A  large  portion  of  the  mine  employees*  wages  is  based 
on  production,  and  tests  of  the  correctness  thereof  can 
readily  be  made.    The  balance  of  the  wages  should  be  care- 


5o8  AUDITING 

fully  scrutinized  and  portions  of  the  pay-rolls  compared 
with  timekeepers'  records. 

Often  mining  companies  own  and  operate  stamping 
mills,  smelters,  short  connecting  railroads,  and  other  en- 
terprises, the  accounts  of  which  should  also  be  carefully 
examined. 

As  the  accounts  and  the  conditions  under  which  various 
mining  enterprises  are  carried  on  differ  widely,  no  set  in- 
structions for  auditing  them  can  be  laid  down;  the  audit 
should,  however,  be  thorough  and  detailed  enough  to  cover 
all  possible  sources  of  income,  to  reveal  operating  waste, 
if  any  exists,  and  to  enable  the  auditor  to  satisfy  himself 
that  no  operating  expenses  are  charged  to  capital  accounts. 
It  is  also  desirable  that  the  scope  of  the  examination  be 
definitely  stated  in  the  auditor's  report. 

Many  companies  charge  discount  on  sale  of  bonds  or 
stocks  to  the  Property  account.  If  such  is  the  case,  the 
auditor  should  endeavor  to  segregate  the  amounts  so 
charged,  or  if  this  cannot  be  done  he  should  make  a  nota- 
tion on  the  balance  sheet  to  the  effect  that  the  Property 
account  includes  such  charges.  The  English  Consolidated 
Companies  Act  of  1908  provides  that  such  discount  should 
be  held  up  as  a  separate  asset  to  be  written  off  out  of  future 
profits,  and  that  it  is  not  allowed  to  be  written  out  of  the 
accounts  in  any  other  way  than  out  of  profits. 

TRADING 
Wholesale  Merchants 

The  audit  of  accounts  of  wholesale  merchants  demands 
extreme  vigilance  on  the  part  of  the  auditor,  because  unless 
the  system  is  complete,  not  only  as  to  financial  transactions 
but  also  as  to  accounting  for  the  actual  stock  received  and 
delivered,  the  discovery  of  loss  by  error  or  fraud,  if  any 
exists,  is  exceedingly  difficult. 


WHOLESALE    MERCHANTS  609 

Comparisons  should  be  made  of  the  stock  records  with 
the  details  of  the  sales  and  purchases  entered  in  the  gen- 
eral books.  These  should  reveal  any  payments  charged  as 
purchases  which  are  not  bona  fide  or  for  which  all  the 
goods  were  not  received.  Theft  of  stock  or  of  the  proceeds 
of  such  as  may  have  been  sold  for  cash,  as  well  as  the 
shipment  of  stock  without  charging  customers  therefor, 
should  also  be  discovered  by  such  comparisons. 

Additional  to  the  possibilities  of  fraud  above  mentioned 
are  those  in  which  attempts  at  concealment  are  made  by 
making  false  entries  on  the  financial  records  only,  such  as 
the  theft  of  customers'  remittances,  in  whole  or  in  part, 
and  allowing  their  accounts  to  remain  open  in  the  ledger, 
or  writing  them  off  through  the  journal  ostensibly  as  bad 
accounts,  or  as  having  been  closed  by  discounts,  allow- 
ances, or  return  of  goods;  by  erroneously  reporting  the 
aggregate  of  cash  sales,  raising  the  amounts  of  vouchers 
covering  cash  paid  for  freight  and  expressage,  etc. 

Particular  care  must  be  exercised  (to  avoid  misstating 
the  business  results)  to  ascertain  that  the  mathematical 
calculations  of  inventory  are  correct,  that  the  unsold  stock 
has  been  priced  at  either  cost  or  market  price — whichever 
is  the  lower — and  that  sufficient  allowance  has  been  made 
for  probable  discounts  on  customers'  accounts  not  yet  due 
in  addition  to  the  usual  reserve  for  uncollectable  accounts, 
depreciation  of  fixtures,  etc. 

In  concerns  doing  an  export  or  import  business,  accounts 
with  foreign  houses  are  usually  kept  in  both  foreign  and 
United  States  currencies.  As  many  of  such  accounts  are 
settled  in  foreign  currency,-  it  is  necessary  to  calculate  at 
the  current  rate  of  exchange  the  equivalent  in  American 
money  of  the  foreign  balances,  and  to  take  up  in  the  Profit 
and  Loss  account  the  differences  between  these  equivalents 
and  the  balances  in  the  accounts  kept  in  American  money. 


5io  AUDITING 

Differences  between  balances  in  foreign  banks  and  the 
equivalent  in  American  money  should  be  adjusted  in  the 
same  manner. 

In  stating  the  results  from  trading,  the  total  sales,  the 
cost  of  sales,  and  the  gross  profit  should  be  shown  sep- 
arately, so  that  the  auditor  may  judge  if  the  percentage  of 
the  latter  is  up  to  the  rate  which  may  reasonably  be  ex- 
pected to  have  been  realized.  The  subject  of  gross  profits 
on  sales  is  treated  in  further  detail  under  the  caption  of 
^'Retail  Merchants." 

Retail  Merchants 

The  volume  of  detail  in  a  retail  business  of  any  size, 
particularly  if  credit  is  extended  to  customers,  is  so  great 
that  it  is  difficult  to  make  a  satisfactory  audit  for  a  moderate- 
sized  fee.  It  is  obvious  that  a  complete  audit  of  all  the 
details  is  out  of  the  question,  but  the  tests  of  the  correct- 
ness of  the  different  sections  of  the  accounts  should  be 
sufficiently  varied  and  comprehensive  to  disclose  any  sys- 
tematic manipulation  of  the  accounts. 

If  the  business  is  a  large  one,  some  system  of  internal 
sales  audit  will  probably  be  in  use.  The  auditor  should 
trace  the  daily  totals  into  the  general  books  and  also  test- 
the  make-up  of  the  daily  totals.  It  may  also  be  possible 
for  him  to  suggest  additional  safeguards  for  the  prevention 
of  irregularities  in  the  handling  of  cash  sales. 

If  the  work  in  connection  with  the  customers'  charge 
accounts  is  properly  systematized,  the  auditor  can  verify 
the  accounts  receivable  with  some  degree  of  assurance. 
The  sales,  returns,  and  allowances  and  cash  totals  should 
all  be  traced  into  the  controlling  accounts  and  the  trial 
balances  of  the  customers  ledger  verified.  A  good  verifica- 
tion of  the  outstanding  balances  is  for  the  auditor  to  com- 
pare the  monthly  statements  at  the  close  of  the  period, 


RETAIL    MERCHANTS  6l  I 

either  with  the  trial  balance,  or  if  that  has  not  yet  been 
prepared,  then  with  the  ledger  itself,  before  the  statements 
are  sent  out. 

It  is  customary  to  allow  employees  of  the  store  a  special 
discount  on  their  purchases  and  also  to  permit  their  ac- 
counts to  run  until  pay  day,  when  settlement  is  made.  If 
these  accounts  are  numerous,  they  should  be  segregated 
either  in  a  separate  ledger  or  in  a  section  of  one  of  the 
customers  ledgers.  The  auditor  should  see  that  none  of 
these  accounts  has  been  permitted  to  run  past  pay  day 
without  settlement  being  made,  and  particularly  that  no 
balances  are  standing  against  persons  who  have  left  the 
employ  of  the  store. 

In  some  businesses,  particularly  those  handling  small 
articles  broken  from  original  packages,  it  is  not  feasible 
to  keep  complete  stock  accounts,  and  some  other  check  on 
the  accounting,  for  the  wares  handled,  must  be  us:ed.  This 
is  found  to  some  extent  in  a  comparison  of  the  rate  of 
gross  profit  earned  in  one  period  as  compared  with  prior 
periods.  Decided  variations  should  be  susceptible  of  definite 
explanation  as  being  due  to  specific  causes ;  a  decrease  in 
the  percentage  of  gross  profit  which  cannot  be  satisfactorily 
explained  raises  at  least  a  presumption  that  the  proceeds 
of  sales  are  not  being  fully  accounted  for,  or  that  pay- 
ments are  being  made  for  goods  which  are  not  actually 
being  received  by  the  house. 

Percentages  of  gross  profit  are  by  almost  all  merchants 
calculated  on  the  sales,  and  not  on  the  cost  of  the  goods 
sold. 

In  some  lines  of  retail  trade,  such  as  cigars,  men's  fur- 
nishing goods,  etc.,  it  is  possible  to  apply  a  check  on  the 
accounting  for  sales,  which  is  also  used  in  some  department 
stores.  The  plan  is  to  charge  all  goods  purchased  to  a 
stock  account  at  their  selling  values;  credits  are  made  on 


6i2  AUDITING 

the  account  for  any  changes  in  selling  prices;  the  inven- 
tories at  beginning  and  end  of  the  period  are  priced  at 
both  cost  and  selling  values,  and  the  latter  values  applied 
in  stock  account  mentioned.  The  crediting  of  the  actual 
sales  of  the  period  should  balance  the  account.  There  will 
naturally  be  some  differences,  but  if  they  are  not  very 
large,  the  sales  can  be  considered  to  have  been  fully 
accounted  for. 

Some  method  of  determining  the  approximate  stock  on 
hand,  even  if  calculated  only  on  the  basis  of  an  estimated 
rate  of  gross  profits  on  sales,  is  needed  by  all  merchants 
for  the  purpose  of  determining  the  proper  amount  of  in- 
surance to  be  carried  on  the  stock,  as  v^ell  as  to  prevent 
overbuying. 

Whenever  several  different  lines  of  good  are  handled, 
both  sales  and  purchases  should,  as  far  as  possible,  be  kept 
separate  for  each  line.  The  rates  of  gross  profits  on  the 
different  lines  will  probably  vary,  and  the  information  as 
to  the  results  of  the  business  done  in  each  class  of  goods 
will  be  valuable  to  the  manager. 

In  a  business  conducted  entirely  on  a  cash  basis,  the 
number  of  customers'  accounts  is  greatly  reduced,  but  they 
are  not  in  all  cases  entirely  eliminated,  as  regular  customers 
often  leave  deposits  to  avoid  the  inconvenience  of  paying* 
separately  for  each  purchase.  The  auditor  should  see  that 
deposit  accounts  are  not  overdrawn,  and  that  if  interest  is 
credited,  it  is  at  the  proper  rate. 

A  quite  general  practice  is  to  issue  a  credit  memoran- 
dum to  customers  returning  goods,  which  memorandum 
may  be  either  applied  in  payment  of  subsequent  purchases 
or  cashed  on  presentation  to  the  cashier.  It  is  desirable 
that  these  credit  memoranda  be  controlled  by  an  account 
on  the  general  ledger.  If  this  is  done,  it  is  possible  for 
the  auditor  to  satisfy  himself,  by  testing  entries  for  credit 


RETAIL    MERCHANTS  613 

memoranda  issued  and  paid,  and  by  reconciling  the  aggre- 
gate of  the  outstanding  memoranda  with  the  balance  of 
the  controlling  account,  that  the  credit  memoranda  have 
been  properly  handled. 

Retail  Shoe  Stores 

The  Bureau  of  Business  Research,  Graduate  School  of 
Business  Administration,  Harvard  University,  in  connection 
with  an  outline  for  a  system  of  accounts  for  retail  shoe 
stores  has  prepared  a  standard  form  of  profit  and  loss 
account.  This  form  is  given  below  as  it  contains  some 
commendable  features. 

Profit  and  Loss  Statement 


A.  Merchandise  Statement: 

I.    (1)   Gross   Sales $ 

Less:   (2)  Returns         $ 

(3)   Allowances  


Net    Sales 

II.  Cost  of  Goods  Sold: 

(4)  Inventory  at  beginning  of  period     . 

(5)  Purchases  at  Billed  Prices     .      . 

(6)  Freight    and    Cartage   on    Purchases 


Cost  of  Stock  Handled  .      .      .      $ 

(7)  Goods  on  Hand  at  end  of  period  at 

Billed    Prices $ 

Less:   (7)   Discounts    on 

Inventory.      $ 

(8)  Depreciation 
and  Shrink- 
age  


(7)   Present    Inventory        

Net   Cost   of   Goods  Sold 

Nominal  Profit  on  Merchandise       ,...$. 
III.    (9)   Discounts  Taken  on  Purchases  (really  deductions  from  cost) 

Gross  Profit  on  Merchandise $. 


6i4 


AUDITING 


Expense  Statement: 

I.  Buying  Expenses: 

(10)  Salaries  and  Wages  of  Buying  Force 

(11)  Other  Buying  Expenses   .      .      .      , 

Total 

II.  Selling  Expenses: 

(12)  Salaries  and  Wages  of  Sales  Force 

(13)  Extra    Selling 

(14)  Advertising: 

(15)  Newspapers    .      .     $... 

(16)  Circulars         

(17)  Other,    including 

displays       


(18)   Miscellaneous    Selling    Expenses 


Total        .... 

III.   Delivery    Expenses: 

(19)   Salaries    and     Wages    of     Delivery 

Force $. 

-     (20)   Other    Delivery    Expenses      ... 


Total 

IV.  Management  Expenses  and  Fixed  Charges: 

(21)  Rent         

(22)  Heat 

(23)  Light        

(24)  Power 

(25)  Repairs  and  Renewals  of  Equipment 

(26)  Depreciation  of  Equipment    . 

i27)  Insurance  on  Stock  and  Equipment 

(28)  Taxes  and    Licenses 

(29)  Management  and   Office   Salaries 

(30)  Office  Supplies  and  Expenses 

(31)  Miscellaneous  Management  Expenses 

Total 


V.   (32)  Losses  from   Bad   Debts    .      .      .      .'    ..     .      . 

Total   Operating   Expenses 

Net  Profit  from  Operation    . 

C.  Other  Business  Profits  (or  Losses): 
I.   (33)  Repairing: 

(34)  Receipts $ 

(35)  Labor $ 

(36)  Materials        


.     $. 


Profit  (or  loss)  on  Repairing 


^.,,.. 


RETAIL    MERCHANTS  615 


II.  i37)  Hosiery: 

(38)  Sales .      .$..... 

(39)  Purchases       .      .      .      .     $ 

(40)  Expenses        , 


Profit   (or  loss)  on  Hosiery    . 

III.   (41)   Extraordinary   Profits  or   Losses    (not  connected 
with    operation) 


Total  Other  Business  Profits  (or  losses)    . 


Net    Nominal    Profit    of    the   period     .      .     $. 


D.  Net  Nominal  Profit  Applied  to: 

I.   (42)   Interest   on    Borrowed   Money $ 

II,   (43)   Interest  on  Capital,  or   (44)    Dividends  on   Capi- 
tal  Stock       

III.   (45)   Final  Net  Profit,  or  Surplus $. 


Explanatory  notes  on  the  foregoing  form : 

Discounts  on  Inventory.  It  is  intended  that  the  inven- 
tory shall  be  net  of  a  figure  arrived  at  by  multiplying  the 
inventory  at  invoice  cost  by  the  average  discount  earned 
during  the  period. 

Depreciation  and  Shrinkage.  The  bureau  recommends 
the  reduction  of  stock  in  hand  arbitrarily  at  the  end 
of  the  first  year  in  business,  by  25,  30,  or  even  33  j/^  per 
cent,  on  the  presumption  that  the  stock  would  not  bring 
more  than  66^  per  cent  at  forced  sale.  The  adoption 
of  this  recommendation  would  be  tantamount  to  creating  a 
heavy  reserve  for  inventory  values  and  adjusting  such  re- 
serve to  meet  increases  or  decreases  at  the  end  of  each 
period.  In  addition,  depreciation  or  shrinkage  in  inven- 
tories, from  any  cause  whatsoever,  should  be  charged  to  this 
account. 

Other  Delivery  Expense.  Includes  stable  or  garage 
rent  and  all  expenses  for  repairs,  up-keep,  and  maintenance 
of  the  delivery  outfit,  including  a  fair  charge  for  deprecia- 
tion. 

Miscellaneous   Management  Expenses.     Includes  tele- 


5i6  AUDITING 

phone,  water,  wages  of  janitors,  porters,  cleaners  and  at- 
tendants, and  any  employees  who  are  not  engaged  in  ad- 
ministrative or  office  work  or  in  buying,  selling,  bundling, 
or  delivery. 

Department  Stores 

A  department  store  is  really  a  group  of  retail  stores  in 
different  lines  of  business  with  one  general  management 
and  with  the  accounting  centralized  in  one  department. 

Practically  all  department  stores  have  a  more  or  less 
efficient  staff  auditing  department.  This  department  pays 
particular  attention  to  the  continuous  auditing  of  the  sales. 
The  volume  of  detail  in  connection  with  the  cash  and  charge 
sales  is  so  great  that  the  professional  auditor  is  not  ex- 
pected to  go  back  of  the  summaries  prepared  by  the  audit- 
ing department.  He  should,  however,  see  that  the  various 
totals  on  the  summaries  are  properly  carried  into  the  general 
books. 

The  auditor  should  also  satisfy  himself  by  careful  in- 
vestigation that  the  system  of  internal  audit  is  such  as  to 
insure  an  accounting  for  all  sales.  It  is  particularly  im- 
portant to  see  that  the  system  of  handling  C.  O.  D.'s  and 
"will  calls"  (similar  to  C.  O.  D.'s,  excepting  that  the  cus- 
tomer will  pay  for  the  goods  on  calling  for  them  at  the 
store,  instead  of  having  them  delivered)  is  such  as  to  re- 
duce the  possibility  of  fraud  or  error  to  a  minimum.  Con- 
trolling accounts  for  these  classes  of  transient  items  are  of 
decided  assistance  in  this  respect. 

The  volume  of  merchandise  purchases  in  a  department 
store  is  very  large,  and  it  is  out  of  the  question  under 
ordinary  circumstances  for  the  auditor  to  examine  2ni  or 
even  a  considerable  part  of  the  purchase  invoices.  Tests 
should  be  made,  however,  and  especial  care  should  be  given 
to  see  that  a  proper  plan  of  verifying  and  approving  each 


DEPARTMENT    STORES  6x7 

invoice  is  in  use  and  that  it  is  actually  carried  out.  Tt  is 
important  that  the  plan  be  such  as  will  guard  against  the 
failure  to  deduct  freight  when  the  goods  are  bought  on  a 
delivered  basis,  shortages  in  weight  or  count,  and  allow- 
ances for  defects  or  inferior  quality.  Frequently  goods 
are  paid  for  before  they  are  actually  received,  in  order  to 
obtain  the  cash  discount  obtainable  for  early  payment.  The 
system  of  approving  invoices  should  insure  such  purchases 
being  verified  on  receipt  of  the  purchased  goods,  and  insure 
that  claims,  if  any  be  in  order,  are  made. 

As  discounts  on  purchases  form  no  small  part  of  the 
net  income  of  department  stores,  it  is  desirable  that  this 
subject  receive  attention  during  the  course  of  the  audit. 
Almost  all  department  stores  are  wide-awake  to  the  im- 
portance of  having  all  invoices  approved  as  quickly  after 
receipt  thereof  as  possible,  so  that  the  discount  day  may  not 
pass  before  the  approved  invoice  reaches  the  treasurer's 
department  for  payment.  Should  the  auditor,  however, 
discover  any  deficiency  or  weakness  in  this  respect,  he 
may  rest  assured  that  his  client  will  very  much  appreciate 
having  his  attention  called  to  the  matter. 

Salaries  and  wages  form  the  largest  single  item  m  the 
expenses,  and  the  verification  of  the  expenditure  therefor 
is  of  prime  importance.  The  padding  of  pay-rolls,  as  far 
as  sales  clerks  are  concerned,  can  usually  be  detected  by 
comparing  the  pay-roll  with  the  auditing  department's 
analysis  of  sales  by  sales  clerks.  Vice  versa,  this  is  also 
somewhat  of  a  check  on  the  statements  of  sales.  The  pay- 
ments for  expenses  will  be  found  to  be  very  voluminous, 
and  it  would  not  be  practicable  to  vouch  them  with  any  ap- 
proach to  completeness.  A  study  of  the  comparisons  shown 
by  the  departmental  accounts  for  different  periods  will, 
however,  indicate  such  of  the  expenses  as  should  be  specially 
investigated. 


6t3  auditing 

Almost  without  exception,  some  form  of  departmental 
accounts,  i.e.,  accounts  showing  the  operations  of  each  de- 
partment separately,  will  be  found  to  be  in  use  in  every 
store.  Their  accuracy  and  completeness  vary :  in  some 
cases  they  are  very  complete  and  are  controlled  by  accounts 
in  the  general  ledger;  in  other  stores  they  are  on  a  single- 
entry  basis,  arbitrary  charges  for  rent,  interest  on  stock, 
and  similar  items  are  made  of  which  no  cognizance  is  taken 
in  the  general  books,  and  no  attempt  is  made  to  bring  the 
aggregate  of  the  results  shown  in  the  departmental  accounts 
into  agreement  with  the  final  results  shown  on  the  general 
books.  It  is  certainly  most  desirable  that  the  departmental 
accounts  be  controlled  by  the  general  ledger,  and  if  the 
system  of  accounts  be  well  laid  out,  it  is  entirely  feasible. 

While  daily  statements  of  sales  and  weekly  or  monthly 
statements  of  profits  (based  on  estimated  inventories)  are 
furnished  to  the  management,  most  stores  close  their  books 
and  state  the  final  results  of  their  business  operations  twice 
a  year,  the  closing  dates  being  either  the  end  of  January 
and  July  or  of  June  and  December.  The  first  half  of  the 
year  is  called  the  spring  season  and  the  latter  half  the  fall 
season.  In  comparing  the  operations  of  a  department  for 
different  periods,  the  comparison  should  always  be  made 
between  the  same  season  in  different  years  and  not  between 
the  two  seasons  in  the  one  year.  The  volume  and  char- 
acter of  the  business  done  in  the  spring  season  varies  con- 
siderably from  that  of  the  fall  season. 

In  studying  the  operations  of  the  various  departments, 
one  of  the  most  important  things  to  be  considered  is  the 
rate  of  gross  profit  on  sales.  Any  undue  fluctuation  therein 
from  one  year  to  another  should  be  thoroughly  investigated. 
Fluctuations  in  the  ratio  of  selling  expenses  to  sales  should 
also  receive  careful  attention.  The  volume  of  business  done 
exerts,  of  course,  a  more  noticeable  influence  on  the  per- 


DEPARTMENT    STORES  619 

centage  which  the  expenses  are  of  the  gross  sales,  than 
should  be  the  case  with  the  gross  profit. 

The  basis  of  the  apportionment  among  the  various  de- 
partments, of  such  expenses  as  delivery  service,  wrapping 
desks,  insurance,  general  administration,  etc.,  ought  to  be 
investigated.  A  rough  and  ready  way  of  distributing  such 
general  charges  may  work  serious  injustice  to  some  de- 
partments, undue  advr.ntage  to  others,  and  result  in  mis- 
leading showings  generally. 

In  verifying  the  assets  and  liabilities,  no  unusual  ques- 
tions of  principle  are  encountered.  The  principal  assets 
are  accounts  receivable  and  merchandise  inventory.  Cus- 
tomers' accounts  receivable  should  be  analyzed  as  to  date; 
this  will  furnish  a  basis  for  the  determination  of  a  proper 
amount  to  be  reserved  for  uncollectable  accounts.  Notes 
receivable  held  by  a  department  store  may  ordinarily  be 
viewed  with  some  suspicion  as  to  the  financial  strength  of 
the  makers.  Goods  sold  at  retail  are  usually  purchased  by 
the  customer  for  consumption  and  not  for  resale;  conse- 
quently, the  account  should  be  paid  at  maturity  and  the 
giving  of  a  note  therefor  is  a  confession  of  the  customer's 
having  purchased  in  excess  of  his  ability  to  pay. 

The  important  questions  in  connection  with  the  inven- 
tory are  the  correctness  of  quantities,  prices,"  arithmetical 
work,  and  salability  of  the  stock.  For  the  correctness  of 
the  quantities  the  auditor  will  be  dependent  largely  on  the 
certification  of  those  who  took  the  inventory  and  of  the 
"buyer"  (department  manager).  The  investigation  of 
large  increases  or  decreases  in  the  inventory  as  compared 
with  prior  dates  will  sometimes  result  in  the  detection  of 
errors  in  quantities.  Prices  may  be  tested  by  reference  to 
the  purchase  invoices.  Goods  which  are  still  in  original 
packages  should  be  inventoried  by  reference  to  the  purchase 
invoice  therefor,  and  verification  thereof  is  comparatively 


620  AUDITING 

simple.  Sufficient  tests  of  the  extensions  and  footings 
should  be  made  to  assure  the  correctness  of  this  element. 
Goods  should  be  so  indicated  on  the  inventory  that  those 
purchased  prior  to  the  current  season  can  be  readily  iden- 
tified and  allowance  made  for  eventual  loss  thereon  owing 
to  the  necessity  for  price  reductions  to  close  them  out. 

Department  store  stocks  and  inventories  are  generally 
calculated  by  what  is  known  as  the  retail  method.  The 
stock  book  has  a  sheet  for  each  department.  The  first 
entry  gives  the  inventory  at  the  beginning  of  the  period  at 
cost,  and  at  selling  prices.  The  invoices  for  each  depart- 
ment are  priced  and  extended  at  selling  prices,  and  weekly 
or  monthly  totals  are  entered  in  the  stock  book  for  both  the 
cost  and  the  selling  prices.  Columns  are  provided  in  the 
stock  book  for  the  mark-down  figures  and  for  the  weekly 
or  monthly  sales  figures.  A  book  inventory  can  be  prepared 
at  the  end  of  each  week  or  month,  as  follows : 

Inventory  at  Selling,  beginning  of  period $ 

Purchases  at  Selling,  to  date  


Total  Inventory  and  Purchases  at  Selling 


Deduct : 
Mark  Downs 
Sales    .     .     . 


Inventory  at  Selling $. . 


To  reduce  to  "inventory  cost,"  multiply  by  ratio  of 
total  of  inventory  and  purchases  at  cost  to  the  total  of 
inventory  and  purchases  at  selling. 

By  ''inventory  cost'"  is  meant  that  figure  which  will 
permit  the  department  to  earn  its  regular  percentage  of 
gross  profit  regardless  of  the  fact  that  a  portion  of  the 
goods  inventoried  might  have  been  reduced  or  ''marked 
down." 


MISCELLANEOUS    DATA    FOR    STORES  621 

There  are  some  who  argue  that  the  ratio  should  be : 

Total  of  Inventory  and  Purchases  at  Cost 
Total  of  Inventory  and  Purchases  at  Selling  less  Mark  Downs 

It  is  obvious  that  the  latter  method  might  result  in  the 
inventory  being  figured  at  a  higher  amount  than  the  cost, 
in  cases  where  there  had  been  heavy  mark  downs  and  prac- 
tically all  of  the  reduced  merchandise  had  been  sold  prior 
to  inventory  taking.  As  we  must  always  have  in  mind 
that  inventories  should  be  priced  at  cost  or  market,  which- 
ever is  the  lower,  the  auditor  should  thoroughly  investi- 
gate the  methods  of  figuring  inventories  where  the  "retail 
method"  is  employed. 

It  is  important  that  the  auditor  should  have  some  knowl- 
edge of  gross  and  retail  profit  figures,  mark  downs,  and 
turnovers.  He  should  endeavor  to  secure  actual  figures 
from  many  sources  to  determine  whether  those  of  his  client 
compare  favorably  with  the  average  results. 

The  author  gives  below  statistics  which  have  been  com- 
piled from  available  data.     The  figures  are  largely  taken    • 
from  articles  appearing  in  System,  which  magazine  has  been 
collecting  data  from  many  sources  on  retail  costs  and  results. 

Miscellaneous  Data  for  Retail  and  Department  Stores 

The  cost  of  delivering  the  average  package  varies  from  >. 
5  to  8  cents  per  package.  .     \   v'-t  * 

A  New  York  department  store  delivered*  1,16S,511 
packages  by  gasoline  vehicles  at  an  average  cost  of  .0643; 
and  1,376,030  packages  by  horse  vehicles  for  .0846  per 
package. 

An  eastern  department  store  reports  that  28  per  cent 
of  its  charge  account  packages  are  returned  and  nearly 
30  per  cent  of  its  C.  O.  D.  orders. 


622 


AUDITING 


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MISCELLANEOUS    DATA    FOR    STORES 


623 


Sales  Salaries 


Small  City  Large  City 

%        % 

Carpets 16               4 

Corsets 

.        5.5            5 

Hosiery 

6.5            6 

Toilet  Goods 

.        6               7 

Gloves 

.        6               6 

Jewelry  and  Leather  ( 

joods 

9               7.5 

Notions 

10               9 

Dress  Goods 

10               9 

Millinery 

11               9 

Shoes 

5.5 

Men's  Clothing     . 

5 

Men's  Hats 

6 

Men's  Furnishings 

5 

Waists 

4 

Candy 

8 

Pianos 

10 

House  Furnishings 

6 

Furniture 

4 

Rugs 

3 

Art       .         .         . 

7 

Books 

6 

Retail  Stores 


Gross  Profits 

% 

Chain  Grocery  Stores 

15  to  49.5 

Cotton  Dress  Goods    . 

32  to  41 

Furniture     ..... 

49 

Hardware,  Large  Store 

33.3 

Large  Department  Store 

24.5 

Ready-made  Clothing 

33.3 

Shoes            

40 

Variety  Goods,  Bargain  Basement 

15  to  25 

Net  Profits 

% 

Dry  Goods  Store     .... 

.      5  to  7 

Furniture 

.     18 

624 


AUDITING 


Grocery    . 

. 

. 

. 

4  to  5 

Large  Department  Store 

3.1    * 

Mail  Order   House          .... 

6.8 

Variety  Goods  Store        .... 

10  to  12 

Variety  Goods,   Bargain   Basement 

5  to  10 

Turnovers* 

Number  of 

Times 

Groceries             ..... 

10 

Department 

7t 

Variety  Goods 

6 

Drugs 

4.5 

Dry   Goods 

4 

Hardware 

3.5 

Furniture 

3 

Shoes 

2.1 

Clothing     . 

2 

Jewelry 

1.5 

Department  Store  Turnovers 


Number  of 

Times 

Bedding 3 

Books          .... 

.         2V^ 

Candy          .... 

.       7 

Chinaware 

2^ 

Clocks          .... 

3 

Clothing  (men's  and  boys') 

SVs 

Coats,  Suits,  and  Dresses 

sy2 

Corsets        .... 

8 

Dress  Goods 

3 

Dry  Goods          .         .         . 

2y2 

*  The  turnover  is  obtained  by  dividing  the  average  inventory  at  selling 
prices  into  the  year's  sales,  or  by  dividing  the  average  inventory  at  cost  into 
the  year's  sales  reduced  to  cost. 

t  The  author's  opinion  is  that  this  is  rather  high  and  that  the  turnover  of 
department  stores  is  from  3  to  5  times.     (See  following  table.) 


MISCELLANEOUS    DATA    FOR    STORES  625 

Embroideries 2 

Furniture  2J4 

Furs 3 

Gloves 3y3 

Handkerchiefs    ......  354 

Hats  (men's  and  boys')      ....  3 

Hosiery       .......  4 

Infants'  Clothing        .....  3^^ 

Jewelry 2 

Jewelry  (toilet  goods,  bags,  and  belts)        .  3^4 

Laces 2]/^ 

Leather  Goods 314 

Linens 2^/3 

Linings 4]/^ 

Men's  Furnishings       .....  4 

Millinery .6 

MusHn  Underwear      .....  3%. 

Neckwear    (women's)  ....  5^4 

Notions 4y3 

Patterns 5 

Pianos         .......  3% 

Ribbons 4 

Rugs 2 

Shoes  (men's,  women's,  and  children's)      .  2^4 

Silks  . 3 

Stationery 2^ 

Suits  and  Coats  (women's  and  misses')      .  81/3 

Toilet  Goods       ......  3>4 

Trunks 35<3 

Umbrellas 6 

Underwear     (knit — men's,     women's,     and 

children's)        ......  4 

Veilings       .......  3 

Wash   Goods       ......  3 

Waists Sy3 


Some  department  stores,  in  fact  quite  a  number  of 
them,  also  have  a  wholesale  department.  Whenever  this 
is  the  case,  the  audit  of  the  accounts  pertaining  to  the 
wholesale  department  will  follow  the  lines  laid  down  un- 
der ''Wholesale  Merchants." 


(^26  AUDITING 

Automobile  Dealers 

It  is  important  that  the  auditor  familiarize  himself 
with  the  terms  of  the  dealer's  contract  with  the  manu- 
facturers. Deposits  with  the  latter  are  not  accounts  re- 
ceivable, but  payments  on  account  of  cars  to  be  purchased 
during  the  contract  period,  and  the  amounts  so  deposited 
may  be  deducted  pro  rata  from  the  price  to  be  paid  for 
each  car  or  from  the  last  shipments.  The  unapplied  bal- 
ance of  such  deposits  should  be  confirmed  by  correspondence 
with  the  manufacturers.  Interest  on  these  deposits  is  some- 
times paid  by  the  manufacturers,  and  where  this  is  the 
case  its  collection  should  be  verified. 

Deposits  by  customers  with  the  dealer  should  appear 
in  separate  accounts,  as  they  are  not  current  accounts  pay- 
able. If  any  interest  is  to  be  allowed  on  such  deposits,  the 
auditor  should  ascertain  that  proper  entries  for  the  accrued 
portion  thereof  have  been  made. 

Cars  on  hand  should  be  physically  examined  and  their 
numbers  compared  with  the  daily  car  record.  The  owner- 
ship of  cars  in  the  possession  of  others  for  alterations  or 
other  purposes  should  be  confirmed  by  correspondence.  The 
invoices  for  unsold  new  cars  should  be  used  to  verify  the 
prices  at  which  they  are  taken  into  the  inventory,  and  the 
second-hand  cars  should  be  appraised,  but  in  no  case  should 
the  appraised  values  exceed  the  allowances  made  to  the 
customers  for  the  cars  plus  the  cost  of  overhauling  them. 
Usually  the  dealer  incurs  a  loss  on  the  sale  of  second-hand 
cars,  and  this  fact  must  be  considered  in  passing  upon  their 
value  for  balance  sheet  purposes. 

Statements  of  accounts  receivable  balances,  after  being 
stamped  with  request  to  communicate  directly  with  the 
auditors  if  not  correct,  should  be  sent  to  all  customers. 
Liberal  allowance  should  be  made  for  the  probable  loss  on 
any  old  or  disputed  accounts. 


AUTOMOBILE    DEALERS  627 

All  accounts  with  manufacturers  should  be  checked 
against  statements  received  from  them.  This  is  important, 
as  allowances  are  often  made  to  satisfy  customers  and 
charged  to  the  manufacturers,  but  for  which  the  latter  will 
not  pass  credit  to  the  dealer. 

The  inventories  should  be  carefully  examined,  all  ob- 
solete parts  eliminated,  and  allowance  made  for  probable 
loss  by  falling  off  in  demand  for  parts  of  cars  manufac- 
tured prior  to  the  audit  year.  In  some  cases  manufacturers 
agree  to  keep  a  certain  quantity  of  parts  on  hand  at  the 
dealers'  repair  shops.  The  value  of  such  consignments 
should  either  be  deducted  from  the  inventory  or  be  shown 
in  a  separate  ledger  account. 

The  correctness  of  the  cost  of  work  in  progress  in  the 
dealer's  repair  shop  should  be  tested  by  examination  of  the 
shop  cards.  All  of  the  cars,  both  new  and  second-hand, 
on  hand  at  the  beginning  of,  and  purchased  during,  the 
audit  period  should  be  accounted  for  as  charged  against 
some  customer  or  as  still  on  hand  at  the  close  of  the  period. 

Tests  should  be  made  of  the  deliveries  from  stock  to 
ascertain  that  parts  and  supplies  are  paid  for  in  cash,  charged 
to  customers  either  directly  or  on  shop  or  road  repair  cards, 
or  are  properly  used  to  repair  demonstrating  cars  and  sec- 
ond-hand cars  taken  in  exchange.  Charges  for  shop  and 
road  repair  work  should  also  be  checked. 

Time  reports  of  workmen  in  repair  shop  and  the  prep- 
aration of  pay-rolls  should  be  investigated  to  ascertain  that 
actual  work  only  is  paid  for,  and  that  it  is  charged  on  shop 
or  road  repair  cards.  Office,  demonstrating,  and  general 
expenses  should  be  vouched  and  compared  with  prior  pe- 
riods. Contracts  with  salesmen  should  be  examined  and 
commissions  paid  to  them  verified. 

A  liberal  reserve  should  be  made  for  free  repairs  to 
sold  cars,  which  are  usually  necessary  during  the  year  sub- 


628  AUDITING 

sequent  to  car  sales  in  order  to  retain  the  good  will  of  cus- 
tomers, but  the  cost  of  which  will  probably  not  be  collected 
from  the  manufacturers. 


Branch  Accounts 

The  close  relation  which  exists  between  a  branch  house 
and  the  parent  concern  presupposes  the  existence  of  com- 
plete records  or  reports  at  the  head  office;  but  it  will  be 
necessary  for  the  auditor  to  ascertain  definitely  how  com- 
plete the  branch  records  are  and  by  what  system  they  are 
reflected  in  the  general  books. 

Some  branches  keep  a  full  set  of  books  and  furnish 
regular  returns  as  required  by  the  home  office.  In  such 
case  the  latter  will  have  but  a  current  account  with  the 
branch  in  the  general  books,  which  will  be  a  controlling 
account,  and  will  represent  the  branch's  capital,  composed 
of  the  assets  at  the  branch  less  the  liabiHties.  Usually  such 
assets  will  be  represented  by  cash,  stock  on  hand,  and  ac- 
counts receivable,  and  in  preparing  the  final  or  consolidated 
balance  sheet,  the  branch  balances  must  be  divided  into 
the  various  classes  of  assets  of  which  they  are  made  up. 
They  should  never  be  treated  simply  as  an  account  receiv- 
able. Where  a  branch  is  not  visited  by  the  auditor,  com- 
plete reports  or  returns  should  be  furnished  him,  properly 
certified,  and  so  far  as  may  be  necessary  he  should  check 
them  into  the  head  office  books.  All  cash  remittances  in- 
cluded in  the  branch  report,  as  well  as  all  cash  sent  from 
the  head  office,  should  be  vouched  in  the  general  books. 
A  reconciliation  of  the  account  between  the  branch  and 
the  head  office  should  be  made,  either  at  a  particular  date 
during  the  audit  or  as  of  some  date  within  the  period  un- 
der review.  The  only  items  affecting  such  reconciliation 
will  be  the  cash  or  invoices  in  transit,  and  these  should 


BRANCH    ACCOUNTS 


629 


subsequently  be  vouched  to  determine  the  absolute  harmony 
between  the  two  sets  of  books. 

Some  concerns  allot  a  permanent  cash  fund  to  each 
branch,  and  require  that  all  receipts  be  deposited  to  the 
credit  of  the  home  office.  In  such  cases  it  will  be  necessary 
to  see  that  the  moneys  received  at  the  branch  appear  on 
the  bank  statement  or  pass-books  as  deposited. 

When  an  auditor  accepts  the  certificate  of  officials  or 
other  persons  for  the  verification  of  assets  at  branches,  he 
should  limit  his  responsibility  by  a  statement  to  that  effect 
in  his  report.  He  should,  however,  satisfy  himself  that 
all  quCvStions  of  principle,  such  as  valuation  of  stocks,  de- 
preciation, reserve  for  bad  debts,  etc.,  have  been  properly 
considered. 

Some  head  offices  now  have  on  file  duplicates  of  all 
records  prepared  by  the  branch  houses.  The  latter  are 
able  to  furnish  these  by  the  use  of  typewriters  or  other 
mechanical  bookkeeping  devices  adapted  for  the  purpose. 
By  one  operation  customers  ledgers  are  posted,  customers' 
monthly  statements  are  written,  and  duplicate  ledger  sheets 
are  prepared  for  the  head  office,  while  duplicate  records 
of  cash  receipts  and  disbursements  form  a  cash  book  with 
which  it  is  possible  to  keep  in  close  touch.  The  facilities 
thus  afforded,  whereby  instant  reference  can  be  had  to 
branch  transactions,  make  possible  a  most  satisfactory 
branch-house  internal  audit  at  the  home  office. 

Goods  billed  to  retail  branches  by  the  head  office  are 
charged  either  at  cost  price,  at  cost  price  plus  a  percentage, 
or  at  selling  price,  inventories  in  each  case  being  taken 
on  a  similar  basis.  For  balance  sheet  purposes  the  auditor 
should  see  that  the  values  of  the  stocks  in  the  last  two  cases 
have  been  reduced  to  cost  or  market  price. 

Schedules  of  debtors  at  the  branch  should  be  submitted, 
duly  certified,  and  the  auditor  should  make  certain  that  all 


630 


AUDITING 


branch  liabilities  not  already  shown  in  the  head  office  books 
have  been  taken  into  account. 

In  making  up  a  balance  sheet  of  the  concern  as  a  whole, 
the  auditor  must  not  overlook  the  fact  that  accounts  between 
branches  and  the  home  office  included  in  controlling  ac- 
counts with  the  ordinary  receivables  and  payables  are  to 
be  eliminated. 

In  addition  to  the  points  mentioned  above,  the  audit  of 
foreign  branches  involves  the  question  of  exchange,  and 
this  requires  that  the  conversion  of  the  various  items  into 
domestic  currency  should  be  checked  and  that  the  difference 
in  exchange  be  ascertained  to  have  been  properly  handled. 
In  the  case  of  English  or  French  currency,  the  rate  of  ex- 
change is  sufficiently  stable  to  warrant  the  accounts  being 
converted  on  a  fixed  basis,  and  the  only  difference  will  then 
be  in  connection  with  remittances.  Where  exchange  fluc- 
tuates, the  value  of  the  fixed  assets  should  be  converted 
into  domestic  currency  at  the  rate  at  which  actually  pur- 
chased, the  current  assets  and  liabilities  at  the  rate  prevail- 
ing at  the  close  of  the  fiscal  period,  and  remittances  during 
the  period  at  the  actual  rate  at  which  made.  If  the  con- 
version results  in  a  loss,  it  should  be  charged  off;  if  a 
profit,  it  is  proper  and  is  sometimes  considered  desirable 
to  carry  it  forward  as  a  reserve  against  possible  losses  in  a 
succeeding  period. 


CHAPTER    XXV 

SPECIAL  POINTS  IN  DIFFERENT  CLASSES  OF 
AUDITS    (Continued) 


PUBLIC  UTILITIES 

For  a  number  of  years  there  has  been  a  growing  ten- 
dency toward  strict  regulation  of  public  service  corpora- 
tions. Wisconsin,  the  pioneer  state  in  this  movement,  has 
for  some  years  had  a  commission  which  has  done  very 
effective  and  progressive  work  in  this  respect,  and  New 
York's  Public  Service  Commissions  (there  being  two,  one 
for  the  counties  of  New  York,  Kings,  Queens,  and  Rich- 
mond, and  the  other  for  the  other  counties  in  the  state), 
which  were  created  in  1907,  have  also  performed  good  ser- 
vice. Some  other  states  have  also  created  similar  commis- 
sions or  have  conferred  real  power  on  formerly  ineffective 
governmental  bodies  which  were  nominally  charged  with 
the  duty  of  regulation,  but  which  were  without  authority 
in  law  to  enforce  their  mandates. 

The  powers  of  the  various  commissions  vary.  In  some 
states  they  have  large  powers,  such  as  the  right  to  grant 
or  deny  franchises,  to  regulate  the  issue  of  stocks,  bonds, 
and  other  evidences  of  corporate  indebtedness,  to  regulate 
rates,  to  issue  mandatory  orders  with  reference  to  opera- 
tion, etc.  One  of  the  powers  with  which  practically  all 
these  newer  commissions  are  vested  is  that  of  prescribing 
imiform  systems  of  accounts  for  the  various  classes  of  pub- 
lic service  corporations  coming  under  their  jurisdiction. 
This  is  rightly  regarded  as  an  important  element  in  the 
proper  regulation  of  the  conduct  of  public  utilities.     Classi- 

631 


632 


AUDITING 


fications  of  accounts  have  been  promulgated  by  the  commis- 
sions of  a  number  of  states  for  electric  railways,  gas  com- 
panies, and  electric  light,  heat,  and  power  companies.  These 
classifications  have  frequently  been  prepared  after  consulta- 
tion with  representatives  of  such  bodies  as  the  American 
Street  and  Interurban  Railway  Accountants'  Association 
and  with  prominent  public  accountants  and  conferences  be- 
tween the  commissioners  of  various  states,  so  that  the  varia- 
tions between  the  classifications  prescribed  by  different 
states  and  by  the  Interstate  Commerce  Commission  (which 
also  exercises  jurisdiction  over  certain  classes  of  public 
service  corporations  other  than  steam  railroads)  are  not 
material.  The  principal  feature  of  these  classifications  which 
might  call  for  criticism  is  a  tendency  toward  too  minute  a 
subdivision  of  the  operating  expenses.  To  relieve  small 
companies  of  the  burden  which  would  be  imposed  by  re- 
quiring them  to  use  in  complete  detail  the  prescribed  classi- 
fications, the  classifications  have  been  condensed  somewhat 
for  moderate-sized  companies,  only  the  very  large  com- 
panies being  required  to  use  the  classifications  in  their 
entirety.  The  distinction  is  drawn  by  making  each  grade 
of  classification  obligatory  on  companies  having  gross  an- 
nual revenues  within  certain  limits. 

The  earliest,  and  still  most  important,  instance  of  gov- 
ernmental regulation  of  public  utilities  was  the  creation  of 
the  Interstate  Commerce  Commission  in  1887  to  supervise 
steam  railroads  transacting  an  interstate  business.  The 
Commission  early  in  its  existence  began  to  require  the  sub- 
mission by  the  railroads  of  annual  reports  prepared  on 
uniform  lines.  In  1906,  a  number  of  very  important  amend- 
ments were  made  to  the  Interstate  Commerce  Act.  The 
jurisdiction  and  powers  of  the  Commission  were  greatly 
extended.  In  addition  to  steam  railroads,  all  electric  rail- 
ways, express  companies,  sleeping-car  companies,  carriers 


PUBLIC    UTILITIES  633 

by  water  (as  described  in  the  act),  pipe  lines  (excepting 
water  and  gas),  and  telephone  companies  whose  business 
activities  are  not  confined  within  the  limits  of  one  state, 
are  subject  to  the  Commission's  authority.  The  Commission 
now  has  the  power  to  fix  maximum  rates — a  power  most 
far-reaching  in  its  effects — not  only  on  the  corporations 
subject  to  its  authority,  but  also  on  the  communities  whose 
ability  to  maintain  their  commercial  supremacy  or  equality 
of  advantage  is  dependent  on  the  fixing  of  fair  rates  as 
compared  with  those  enjoyed  by  competitive  points.  An- 
other notable  broadening  of  its  powers  was  the  conferring 
of  the  right  to  prescribe  a  uniform  system  of  accounts  for 
each  class  of  corporations  subject  to  its  authority,  and  the 
enforcement  thereof  by  making  deviation  therefrom  a  penal 
offense.  This  \^;as  an  important  development  of  the  limited 
power  formerly  enjoyed  of  calling  for  uniform  reports. 

A  most  important  feature  of  the  new  classification  of 
accounts  for  steam  railroads  promulgated  after  the  enact- 
ment of  the  amendments  of  1906,  is  the  requirement  that 
periodically  entries  be  made  for  depreciation  of  equipment. 
It  may  well  be  expected  that  in  time  depreciation  charges 
will  also  be  required  to  be  made  for  all  other  parts  of  the 
physical  property  which  are  subject  to  depreciation  or  grad- 
ual exhaustion.  This  recognition  by  a  governmental  body 
of  a  fundamental  accounting  principle  is  gratifying  to  ac- 
countants, who  stood  for  years  practically  alone  in  their 
advocacy  of  the  need  for  depreciation  charges  in  the  accounts 
of  railroads  and  all  other  public  utilities. 

State  legislatures  can  enact,  and  in  some  cases  already 
have  enacted,  laws  delegating  to  commissions  or  municipali- 
ties power  to  fix  the  rates  to  be  charged  by  public  service 
corporations  operating  within  the  state.  Under  these  cir- 
cumstances the  auditor  has  responsibilities  additional  to 
those  which  simply  consider  the  stockholders.     In  a  sense 


634 


AUDITING 


he  stands  between  the  company  and  the  public.  Should 
depreciation  allowances  and  other  necessary  reserves  be 
omitted  from  the  accounts,  the  apparent  profits  shown  will 
be  larger  than  is  actually  the  case  and  may  result  in  an 
agitation  for  a  reduction  in  rates  charged  to  consumers 
which  the  real  facts  in  the  case  do  not  justify.  In  the  en- 
suing litigation  it  will  probably  be  very  difficult  to  convince 
either  judge  or  jury  that  depreciation  charges,  etc.,  which 
were  not  made  at  the  proper  time  should  now  be  allowed  as 
an  element  in  the  cost  of  operation.  On  the  other  hand,  if 
the  reserves  for  depreciation  and  the  like  are  excessive,  the 
profits  will  be  shown  at  less  than  their  real  figures  and  the 
public  will  be  deceived. 

The  importance  of  this  subject  was  recognized  at  a 
national  gathering  of  public  accountants*  as  long  ago  as 
1904,  when  a  paper  on  the  subject  was  read  and  a  special 
committee  was  appointed  to  consider  the  matter.  This 
committee  later  reported  as  follows : 

The  committee  appointed  at  the  Congress  of  Accountants,  held  at 
St.  Louis,  U.  S.  A.,  in  September,  1904,  to  review  the  paper  by  Robert 
H.  Montgomery,  C.P.A.,  upon  "The  Importance  of  Uniform  Practice 
in  Determining  the  Profits  of  Public  Service  Corporations  Where 
Municipalities  Have  the  Power  to  Regulate  Rates,"  having  taken  the 
paper  into  consideration,  have  come  to  the  following  conclusions,  and 
now  beg  to  state  the  same  as  their  opinion  upon  the  questions  raised : 

I.  A  distinction  must  be  made  between  the  profits  of  an  under- 
taking from  the  point  of  view  of  the  general  community  and  the  profits 
available  for  dividends  from  the  point  of  view  of  a  corporation  owning 
such  undertaking.  The  former  would  be  the  net  earnings  from  the 
operation  of  the  undertaking,  after  providing  for  all  waste  or  deprecia- 
tion of  capital  assets  arising  directly  out  of  such  operation;  while  the 
latter  would  be  arrived  at  only  after  providing  also  for  any  possible  loss 
on  capital  assets  arising  from  causes  not  directly  incident  to  such 
operation  and  for  interest  on  borrowed  money. 

II.  The  net  earnings  of  a  public  utility  with  which  the  general 
community  is  concerned  are  determined  by  the  excess  of  gross  earnings 
over  the  expenses,  defining  the  latter  terms  as  follows :  Gross  earnings 
consist  of  the  charges  for  all  services  rendered  during  the  period  as 


PUBLIC    UTILITIES  635 

distinguished  from  mere  receipts,  but  would  exclude  incidental  earnings 
not  arising  out  of  the  operation  of  the  utility,  such  as  interest  on 
investments. 

Expenses  consist  of:  (1)  The  direct  cost  of  operation  and  of 
maintenance  (ordinary  repairs),  expenses  of  management,  and  provi- 
sions for  bad  debts,  damage  claims,  and  rebates,  as  well  as  extraordinary 
expenses  incurred  during  the  period,  such  as  legal  charges,  etc.,  but 
they  should  not  include  interest  on  borrowed  money,  discounts  on 
bonds  issued,  or  other  charges  in  connection  with  the  promotion  or 
financing  of  the  undertaking.  (2)  Depreciation:  (a)  On  plant — 
physical — covering  wear  and  tear,  including  direct  requirements  for 
renewals,  etc.,  arising  both  from  known  and  probable  causes,  such  as 
electrolysis,  etc.  (b)  On  plant — indirect — due  to  obsolescence  and  the 
like,  but  not  that  due  to  a  fall  in  value  from  general  causes,  (c)  On 
other  capital  assets  which  are  diminishing  in  value  as  a  direct  result 
of  the  operation  of  the  property,  such  as  moneys  properly  expended 
in  acquiring  from  the  local  authorities  the  franchise  under  which  the 
utility  is  operated  where  such  franchise  is,  as  is  usually  the  case, 
terminable  after  a  certain  number  of  years ;  or  cost  of  mines,  quarries, 
or  other  similar  properties  which  are  being  used  up  continuously  for 
the  purpose  of  operating  the  utility.  But  there  should  not  be  included 
any  provision  for  recouping  promoters'  profit  or  other  watered  capital, 
or  for  possible  loss  by  reason  of  a  general  fall  in  values,  etc.,  on  the 
purchase  at  the  end  of  the  franchise  of  the  whole  undertaking  by  the 
public  authorities,  i.e.,  the  state  or  municipality. 

III.  In  dealing  with  the  private  accounts  of  a  corporation  operating 
the  utility,  earnings  will  also  embrace  miscellaneous  receipts,  if  any, 
not  connected  with  the  actual  operations  of  the  undertaking,  and  the 
following  additional  expenses  should  be  allowed  for  before  arriving 
at  a  bafeitee  available  for  distribution : 

(1)  Depreciation:  An  additional  amount  to  cover  any  excess  of 
the  book  value  of  good-will,  franchise,  and  plant  over  that  provided  for 
under  section  2,  subsection  (c)  above,  or  over  the  sum  it  may  be 
expected  to  realize  on  the  expiry  of  the  franchise. 

(2)  Interest:   On  bonds  or  other  funded  or  floating  debt. 

IV.  In  determining  the  rates  which  should  be  charged  to  the  pub- 
lic, regard  must  be  had  (a)  to  the  profit  ascertainable  under  section  II, 
and  (b)  to  further  charges  specified  under  section  III,  which  would 
have  to  be  borne  by  the  corporation  out  of  such  profits.  For  instance, 
if  8  per  cent  per  annum  on  the  capital  invested  is  considered  a  reason- 
able rate  for  a  corporation  to  earn,  taking  into  consideration  the  risks 
in  section  III,  then  the  rates  should  be  fixed  so  as  to  allow  of  a  profit 
of  8  per  cent  calculated  as  laid  down  in  section  II,  and  out  of  this 


536  •     AUDITING       • 

profit  the  corporation  would  have  to  provide  for  the  risks  and  expenses 
stated  in  section  III. 

A.  Lowes  Dickinson  Ernest  Reckitt 

Elijah  W.  Sells  John  B.  Niven 

Harvey  S.  Chase  Robert  H.  Montgomery,  Chairman 

One  of  the  most  vital  questions  confronting  the  audi- 
tor of  public  utility  accounts  is  the  separation  of  all  ex- 
penditures into  the  two  classes  of  capital  and  revenue,  or — 
as  they  are  more  often  termed  in  practice — construction 
and  maintenance.  Frequently  expenditures  are  of  such  a 
nature  that  it  is  open  to  debate  as  to  whether  they  belong 
in  the  one  class  or  the  other. 

A  factor  which  contributes  to  make  the  distinction  diffi- 
cult is  that  most  public  service  corporations,  particularly 
railways  and  light  and  power  plants,  do  not  have  any  but 
very  extensive  additions  to  plant  made  by  outside  contrac- 
tors. The  work  is  done,  under  the  direction  of  their  own 
engineers,  by  their  own  workmen.  As  these  same  forces 
also  do  the  current  maintenance  work  and  use  the  same 
kinds  of  materials  for  construction  as  for  maintenance  pur- 
poses, it  is  practically  impossible  to  determine  merely  from 
the  nature  of  the  labor  and  material  expenditures  whether 
they  are  capital  or  revenue  charges. 

The  only  satisfactory  solution  of  the  problem  is  for  the 
company  to  keep  such  cost  accounts  of  its  construction  work 
as  will  relate  the  expenditures  to  the  thing  done  or  ac- 
complished. It  is  then  possible  for  the  auditor  to  satisfy 
himself  by  conference  with  the  company's  engineer,  as  well 
as  by  his  experience  with  other  engagements  in  the  same 
field,  whether  or  not  the  capital  charges  are  proper.  Un- 
fortunately, many  companies  do  not  keep  such  construction 
cost  records,  though  all  should.  Where  they  are  lacking, 
one  of  the  best  things  for  the  auditor  to  do  is  to  have  the 
engineering  department  submit  a  statement  of  the  construe- 


PUBLIC    UTILITIES 


^Z7 


tion  work  done  during  the  period  under  review  and  the 
legitimate  cost  of  each  part  thereof.  Such  a  statement  will 
usually  be  of  material  assistance  in  passing  on  expenditures 
which  have  been  charged  to  Capital  account.  The  best- 
managed  companies  have  a  system  of  ''Construction  Au- 
thorizations" which  are  prepared  by  the  engineering  staff 
and  approved  by  the  board  of  directors  or  executive  com- 
mittee. These  authorizations  form  the  best  basis  for  con- 
struction cost  accounts. 

Charges  for  additional  equipment  are  usually  more 
easily  traced,  and  there  is  not,  as  a  rule,  much  difficulty 
in  coming  to  a  conclusion  as  to  whether  the  charges  should 
go  to  capital  or  revenue. 

While  it  is  advisable  that  in  cases  of  doubt  the  decision 
be  in  favor  of  the  conservative  policy  of  charging  the  items 
in  doubt  to  maintenance,  yet  excessively  conservative  prac- 
tice must  also  be  avoided,  as  it  increases  the  apparent  cost 
of  service  rendered  and  consequently  is  unjust  to  the  con- 
sumers. 

There  is  no  question  but  that  the  cost  of  the  original 
plant  and  all  extensions  and  additions  are  proper  capital 
charges.  Reconstruction  expenditures  frequently  give  oc- 
casion to  much  doubt  as  to  their  proper  apportionment. 
If  the  reconstruction  has  resulted  in  increased  capacity, 
some  portion  thereof  is  properly  chargeable  to  capital.  The 
most  equitable  plan  is  to  charge  to  capital  the  reconstruction 
cost,  and  eliminate  therefrom  the  cost  of  the  construction 
work  or  equipment  which  has  been  replaced.  The  result 
is  that  the  plant  always  stands  on  the  books  at  the  last  cost, 
i.e.,  the  cost  of  the  plant  as  it  stands  at  the  present  time. 
In  cases  involving  the  determination  of  rates  which  are 
equitable  to  the  consumers  and  yet  at  the  same  time  yield 
a  fair  return  on  the  actual  investment,  it  is  certainly  most 
satisfactory  to  have  the  investment  in  plant  appearing  at 


638 


AUDITING 


the  cost  of  the  present  plant,  and  not  at  the  cost  of  the 
plant  as  it  was  at  some  earlier  date. 

In  considering  the  question  of  a  proper  charge  for  de- 
preciation of  plant,  which  is  an  element  in  the  cost  of  serv- 
ice rendered  (see  section  II,  subsection  2  (a)  of  the  report 
supra),  it  would  seem  that  it  should  be  based  on  the  cost 
of  the  plant  in  operation.  This  would  necessarily  include 
the  last  cost  of  any  parts  of  the  plant  which  might  have 
been  reconstructed  or  replaced  since  its  original  construction. 

The  Supreme  Court  of  Idaho  made  a  legal  definition 
of  depreciation  in  a  decision  handed  down  in  the  case  of 
Murray  v.  The  Public  Utilities  Commission  of  the  State 
of  Idaho.    In  handing  down  its  decision,  the  court  said : 

So  far  as  the  question  of  depreciation  is  Goncerned,  we  think  de- 
duction should  be  made  only  for  actual  tangible  depreciation  and  not 
for  theoretical  depreciation,  sometimes  called  "accrued  depreciation." 
In  other  words,  if  it  be  demonstrated  that  the  plant  is  in  good  operating 
condition  and  giving  as  good  service  as  a  new  plant,  then  the  question 
of  depreciation  may  be  entirely  disregarded. 

This  decision  was  rendered  in  a  case  where  an  endeavor 
was  made  to  show  that  accrued  depreciation  should  be  de- 
ducted from  original  cost  before  arriving  at  the  value  of 
the  plant  for  the  purpose  of  fixing  rates. 

In  a  decision  the  Public  Service  Commission  for  the 
First  District  of  New  York  said : 

The  cost  of  moving  a  track  from  one  location  to  another,  and 
installing  new  ties,  rails,  etc.,  is  necessarily  an  element  of  operating 
expense,  whether  incurred  in  consequence  of  wear  and  tear,  or  of 
obsolescence  and  inadequacy.  It  is  so  treated  in  the  accounting  systems 
of  this  Commission  and  the  Interstate  Commerce  Commission.  Every 
well-managed  corporation,  before  ascertaining  profits  and  declaring 
dividends,  sets  aside  some  portion  of  its  revenue  to  provide  for 
extraordinary  replacements  that  are  not  properly  charged  to  the 
operating  expenses  of  a  single  year. 

In  a  recent  case  the  United  States  Supreme  Court  ren- 


PUBLIC    UTILITIES  639 

dered  a  unanimous  judgment  in  which  it  held  (thereby 
affirming  the  Commerce  Court)  that  the  Interstate  Com- 
merce Commission  has  authority  to  require  interstate  rail- 
ways to  charge  to  operating  expenses  portions  of  the  cost 
of  providing  enlarged  facilities  necessary  to  meet  the  re- 
quirements of  increased  traffic.  The  occasion  for  this 
decision  was  a  suit  by  the  Kansas  City  Southern  Railway 
to  obtain  relief  from  an  interpretation  of  one  of  the  gen- 
eral accounting  orders  of  the  Commission,  the  substantial 
requirements  of  which  are  as  follows : 

1.  When  property  is  abandoned  and  not  replaced  in 
kind,  the  estimated  cost  of  replacing  it  must  be  deducted 
from  the  cost  of  property  carried  in  the  balance  sheet  and 
charged  to  profit  and  loss. 

I  2.  When  property  is  abandoned  as  an  incident  of  im- 
provements and  replaced  by  more  efficient  property  of  like 
kind,  only  so  much  of  the  cost  of  providing  the  improve- 
ments can  be  added  to  the  item  in  the  balance  sheet  which 
represents  cost  of  property,  as  may  remain  after  deducting 
from  the  actual  cost  the  estimated  replacement  cost  of  the 
property  abandoned,  and  the  latter  must  be  charged  to  cost 
of  operation. 

A  leading  financial  writer  commented  thereon  as  follows : 

"If  a  six-story  building  is  torn  down  to  be  replaced  by 
a  twenty-story  building,  the  cost  of  the  new  property  in- 
cludes the  cost  of  the  old  building  as  well  as  that  of  the 
land  on  which  it  stands,  and  if  the  twenty-story  building 
is  in  turn  replaced  by  one  of  fifty  stories,  both  its  prede- 
cessors are  represented  in  the  cost  of  the  last. 

*' Without  such  replacements  there  could  be  no  progress ; 
their  cost  is  the  cost  of  progress.  This  being  the  economic 
fact,  it  is  plain  that  any  regulations  of  the  Interstate  Com- 
merce Commission  that  are  in  conflict  therewith  must  have 
one  of  two  consequences :  they  must  either  (first)  prevent 


640 


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the  progress  that  ought  to  take  place,  or  (second)  they 
must  become  dead-letters.  Neither  result  is  desired  nor 
desirable.  The  plain  necessity  of  the  situation  resulting 
from  Monday's  decision  is  that  the  Interstate  Commerce 
Commission  should  reconsider  its  accounting  rules  and  sub- 
stitute a  more  liberal  and  constructive  regulation  for  that 
in  question/* 

While  there  is  necessarily  a  different  classification  of 
accounts  for  each  of  the  various  classes  of  public  utilities, 
the  general  principles  underlying  all  of  them  are  the  same. 
A  committee  of  the  American  Association  of  Public  Ac- 
countants submitted  to  the  1907  convention  of  the  Asso- 
ciation the  following: 

Standard  Schedule  of  Revenue  and  Expense 
(Income  and  Expenditure) 

For  Municipal  Industries  and  Public  Service 
Corporations 

Revenue  from  Operating 

Gross  Earnings  from  Public  Services $ 

Gross  Earnings  from  Private  Consumers 

Gross  Earnings  from  By-Products,  etc 


Total $. 

Deduct  Rebates,  Refunds,  Discounts,  etc 


Total  Revenue  from  Operating $. 

Expense  of  Operating 

1.  Expense  of  Manufacture: 

Operation $ 

Maintenance   

Product  Purchased  (Gas,  etc.) 

2.  Expense  of  Distribution: 

Operation  

Maintenance   


PUBLIC    UTILITIES  641 


3.  General    Expense    (Salaries,    Office    Supplies 

and  Expenses) 

Total  (1,  2,  and  3) $. 

4.  Taxes  (Real  Estate  and  Other) 

5.  Franchise  Taxes    (paid  or  accrued  annually 

or  otherwise) 

6.  Rentals  (Leaseholds,  etc.) 

7.  Insurance  (Fire,  Accident,  and  Fiduciary)...     . 

8.  Damages  (including  Extraordinary  Legal  and 

Other  Expenses  and  Losses) 

9.  Guaranty    (Bad  Debts  Written  Off  and  Re- 

serve for  Doubtful  Accounts) 

10.  Depreciation   (Deterioration  Written  Off  and 
Reserve  for  Estimated  Depreciation) 

Total  Expense  of  Operating 


(a)  Net  Revenue  from  Operating  (or  Deficiency) $. 

(b)  Other    Revenue    or    Income,    Net    (from    Sources 

Other  Than  Operating) 

(c)  Appropriations    for    Operating,    Provided    by    the 

Municipality  from  General  Funds 


Total   Available   Income $. 

Disposition  of  Available  Income 
11.  Interest  on  Funded  and  Floating  Debts 


Remainder  of  Available  Income $ 

12.  Reserved  for  Sinking  Funds $ 

13.  Reserved  for  Amortization  Funds 

14.  Reserved  for  Other  Funds \ 


Total   Reserves 

15.  Dividends    (Private  Plants) 

16.  Appropriation  to  General  City  Funds  (Public 

Plants)    

Total  Disposition  of  Available  Income. 


Credit  (or  Debit)  balance  transferable  to  "Sur- 
plus"       $. 


Note  :   The  various  items  in  this  condensed  statement  (particularly 
expense  items  1,  2,  and  3)  should  be  supported  by  detailed  schedules. 


642 


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This  is  a  condensed  form  suitable  for  any  form  of  pub- 
lic utility — railway,  gas,  electric  light  and  power,  water 
works,  or  telephone — and  would  be  accompanied  by  sched- 
ules giving  the  details  pertaining  to  the  particular  utility 
for  which  used.  It  would  be  especially  useful  in  compar- 
ing the  operations  of  different  undertakings,  as  it  brings 
out  quite  distinctly  those  items  whose  treatment  is  a  mat- 
ter of  judgment,  such  as  depreciation,  or  which  for  any 
other  reason  may  be  considered  as  "variables." 

The  exhaustive  report  of  the  National  Civic  Federation 
on  "Municipal  and  Private  Operation  of  Public  Utilities," 
issued  in  1907,  will  be  of  both  interest  and  value  to  the 
accountant  who  wishes  to  devote  especial  attention  to  the 
accounts  of  public  service  corporations. 

Rate  Regulation 

The  tendency  of  legislation  for  the  regulation  of  rates 
to  be  charged  by  public  service  corporations  is  to  limit 
them  to  such  rates  as  will  not  yield  more  than  a  moderate 
return  on  the  capital  actually  invested.  As  the  accounts 
of  but  very  few  companies  have  been  kept  in  such  a  way 
as  to  exhibit  clearly  or  conclusively  the  cost  of  the  plant, 
not  to  mention  proper  allowances  for  depreciation,  one  of 
the  first  steps  when  fixing  of  rates,  renewals  of  franchises, 
or  similar  negotiations  are  under  consideration,  is  to  have 
the  property  appraised. 

In  a  decision  of  the  New  Jersey  Board  of  Public  Utility 
Commissioners,  appears  the  following: 

The  general  principles  which  underlie  all  just  valuations  for 
rate-making  purposes  are  simple.  These  great  general  underlying 
principles  are  two  in  number.  The  first  aims  at  securing  for  con- 
sumers generally  a  prompt  and  adequate  supply  at  reasonable  rates, 
of  those  services  which  they  require  of  public  utility  companies.  To 
insure  this  end  a  sufficient  incentive  must  be  held  out  to  enterprises 
and  investors.    Such  an  incentive  is  the  assured  prospect  of  a  sufficient 


PUBLIC    UTILITIES 


643 


return  upon  outlay  in  supplying  service.  The  first  general  principle  is 
prospective  in  its  reach;  it  looks  to  the  future.  It  is  comprehensive 
in  its  aim,  it  is  bent  on  obtaining  the  adequate  supply  of  community 
wants. 

The  second  general  underlying  principle  seeks  to  conserve  the 
legitimate  value  of  investments  in  public  utility  enterprises.  It  regards 
the  past  rather  than  the  present,  the  individual  investors  rather  than 
the  community  of  consumers.  It  is  perfectly  consonant  with  the  first 
general  principle  enunciated.  For  unless  the  legitimate  value  of  past 
investments  is  preserved  by  rate-making  decisions,  the  effective  incen- 
tive for  individuals  to  take  similar  risks  in  the  future  is  impaired  or 
extinguished. 

In  the  Kings  County  Lighting  Co.  case  decided  by  the 
New  York  Court  of  Appeals  March  24,  1915,  the  court 
said: 

The  public  is  entitled  to  reasonable  rates  and  the  company  to  a 
fair  return  on  its  property;  and  in  determining  what  is  a  fair  return 
there  must  be  taken  into  account  the  cost  of  developing  the  business 
after  it  was  started  and  of  building  it  up  and  placing  it  on  a  paying 
basis.  If  it  received  a  fair  return  on  its  investment  from  the  start, 
or  if  in  later  years  it  received  more  than  a  fair  return  and  made  up 
for  the  lean  years,  then,  the  Court  says,  that  is  the  end  of  the  matter 
so  far  as  "going  value"  is  concerned.  But  if  it  did  not  receive  a  fair 
return  in  the  early  years  and  the  deficiency  has  not  been  made  up, 
and  it  was  due  to  losses  or  expenses  which  were  reasonable,  necessary 
and  proper  in  developing  efficiency  and  economy  of  operation  and  in 
establishing  the  business,  then  the  item  of  "going  value"  comes  in  and 
must  be  considered  in  fixing  the  rate;  otherwise  the  rate  would  be 
confiscatory. 

In  determining  what  is  "going  value"  and  how  it  is  to  be  appraised, 
Judge  Miller  points  out  that  it  takes  time  to  put  a  new  enterprise  of 
any  magnitude  on  its  feet  after  the  construction  work  has  been 
finished.  Mistakes  of  construction  have  to  be  corrected.  Substitu- 
tions have  to  be  made.  Economics  have  to  be  studied.  Experiments 
have  to  be  made,  which  sometimes  turn  out  to  be  useless.  An  organi- 
zation has  to  be  perfected.  Business  has  to  be  solicited  and  advertised 
for.  In  the  case  of  a  gas  company,  gratuitous  work  has  to  be  done, 
such  as  selling  appliances  at  less  than  a  fair  profit  and  demonstrating 
new  devices  to  induce  consumption  of  gas  and  to  educate  the  public 
up  to  the  maximum  point  of  consumption.  None  of  those  things  is 
reflected   in   the   value   of   the  physical  property,   unless,   of   course, 


644 


AUDITING 


exchange  value  be  taken,  which  is  not  admissible  in  a  rate  case.  The 
company  starts  out  with  the  "bare  bones"  of  the  plant — to  borrow 
Justice  Lurton's  phrase  in  the  Omaha  Water-Works  case.  By  the 
expenditure  of  time,  labor,  and  money  it  co-ordinates  those  bones  into 
an  efficient  working  organism  and  acquires  a  paying  business.  The 
proper  and  reasonable  cost  of  doing  that,  whether  included  in  operat- 
ing expenses  or  not,  is  as  much  a  part  of  the  investment  of  the  com- 
pany as  the  cost  of  the  physical  property. 

The  investors  in  a  new  enterprise  have  to  be  satisfied  as  a  rule 
with  meager  or  no  returns  while  the  business  is  being  built  up.  In  a 
business  subject  only  to  the  natural  laws  of  trade  they  expect  to 
make  up  for  the  early  lean  years  by  large  profits  later.  In  a  business 
classified  among  public  callings,  the  rate  making  power  must  allow  for 
the  losses  during  the  lean  years  or  their  rate  will  be  confiscatory,  and, 
of  course,  will  drive  investors  from  the  field.  In  the  former  case  the 
value  of  the  established  business  is  a  part  of  the  "good-will"  and  may 
be  determined  by  taking  a  given  number  of  years'  purchase  of  the 
profits,  or  exchange  value  may  be  considered.  In  the  latter  case  a 
different  rule  must  be  adopted.  To  view  the  matter  in  another  aspect, 
take  the  case  of  a  public  service  corporation  with  a  plant  constructed 
just  ready  to  serve  the  public.  It  is  going  to  take  time  and  cost 
money  to  develop  the  highest  efficiency  of  the  plant  and  to  establish 
the  business.  Three  courses  seem  to  be  open  with  respect  to  rate 
making,  viz.:  (1)  to  charge  rates  from  the  start  sufficient  to  make  a 
fair  return  to  the  investor  and  to  pay  the  development  expenses  from 
earnings — a  course  likely  to  result  in  prohibitive  rates,  except  under 
rare  and  favorable  circumstances;  (2)  to  treat  the  development  ex- 
penses as  a  loss  to  be  recouped  out  of  earnings,  but  to  be  spread  over 
a  number  of  years,  in  other  words,  as  a  debt  to  be  amortized ;  that 
involves  complications,  but  would  seem  to  be  fairer  to  the  public  and 
certainly  more  practical  than  the  first;  (3)  to  treat  the  development 
expenses,  whether  paid  from  earnings  or  not,  as  a  part  of  the  capital 
account  for  the  purpose  of  fixing  the  charge  to  the  public.  The  last 
course  would  seem  to  be  fairest  to  both  the  public  and  the  company, 
as  well  as  the  most  practical. 

Obviously  the  most  satisfactory  method  is  to  show  the  actual 
experience  of  the  company,  the  original  investment,  its  earnings  from 
the  start,  the  time  actually  required  and  expenses  incurred  in  build- 
ing up  the  business,  all  expenditures  not  reflected  by  the  present 
condition  of  the  physical  property,  the  extent  to  which  bad  manage- 
ment or  other  causes  prevented  or  depleted  earnings,  and  any  other 
facts  bearing  on  the  question,  keeping  in  mind  that  the  ultimate  fact 
to  be  determined  is  not  the  amount  of  the  expenditures,  but  the 
deficiency  in  the  fair  return  to  the  investors  due  to  the  causes  under 


PUBLIC    UTILITIES  643 

consideration.  The  business  in  this  case  was  twenty  years  old,  the 
books  of  the  old  company  were  not  available,  and  it  is  of  course 
problematical  whether,  if  produced,  they  would  have  shown  the  neces- 
sary facts.  The  question,  therefore,  had  to  be  determined,  as  all 
questions  of  fact  have  to  be,  by  the  best  evidence  available. 

A  gas  and  electric  light  company  in  its  application  to 
the  Wisconsin  Railroad  Commission  for  authority  to  in- 
crease its  rates,  added  12  per  cent  to  the  cost  of  land, 
buildings,  and  equipment  for  engineering  superintendence, 
interest  during  construction,  contingencies,  etc.  The  Com- 
mission allowed  the  12  per  cent  addition  for  purposes  of 
arriving  at  a  valuation  of  the  plant. 

Appraisals  of  Public  Utilities 

Congress  amended  the  Interstate  Commerce  Commis- 
sion Act  in  March,  1913,  so  as  to  provide  for  a  valuation 
of  the  several  classes  of  property  of  interstate  carriers  and 
to  secure  information  concerning  their  stocks,  bonds,  and 
other  securities.     The  amendment  provides  that: 

The  Commission  shall  make  an  inventory  which  shall  list  the 
property  of  every  common  carrier  subject  to  the  provisions  of  this 
Act  in  detail,  and  show  the  value  thereof  as  hereinafter  provided,  and 
shall  classify  the  physical  property,  as  nearly  as  practicable,  in  con- 
formity with  the  classification  of  expenditures  for  road  and  equipment 
as  prescribed  by  the  Interstate  Commerce  Commission.  First:  In  such 
investigation  said  Commission  shall  ascertain  and  report  in  detail  as  to 
each  piece  of  property  owned  or  used  by  said  common  carrier  for  its 
purposes  as  a  common  carrier,  the  original  cost  to  date,  the  cost  of 
reproduction  new,  the  cost  of  reproduction  less  depreciation,  and  an 
analysis  of  the  methods  by  which  these  several  costs  are  obtained,  and 
the  reason  for  their  differences,  if  any.  The  Commission  shall  in  like 
manner  ascertain  and  report  separately  other  values,  and  elements  of 
value,  if  any,  of  the  property  of  such  common  carrier  and  an  analysis 
of  the  methods  of  valuation  employed,  and  of  the  reasons  for  any 
differences  between  any  such  value  and  each  of  the  foregoing  cost 
values.  Second :  Such  investigation  and  report  shall  state  in  detail 
and  separately  from  improvements,  the  original  cost  of  all  lands,  rights 
of  way,  and  terminals  owned  or  used  for  the  purposes  of  a  common 


646 


AUDITING 


carrier  and  ascertained  as  of  the  time  of  dedication  lo  public  use  and 
the  present  value  of  the  same,  and  separately  the  original  and  present 
cost  of  condemnation  and  damages  or  of  purchase  in  excess  of  such 
original  cost  or  present  value.  Third:  Such  investigation  and  report 
shall  show  separately  the  property  held  for  purposes  other  than  those  of 
a  common  carrier  and  the  original  cost  and  present  value  of  the  same 
together  with  an  analysis  of  the  methods  of  valuation  employed. 
Fourth :  In  ascertaining  the  original  cost  to  date  of  the  property  of  such 
common  carrier,  the  Commission  in  addition  to  such  other  elements  as 
it  may  deem  necessary,  shall  investigate  and  report  upon  the  history 
and  organization  of  the  present  and  of  any  previous  corporation 
operating  such  property;  upon  any  increases  or  decreases  of  stocks, 
bonds,  or  other  securities,  in  any  reorganization,  upon  moneys  re- 
ceived by  any  such  corporation  by  reason  of  any  issues  of  stocks, 
bonds,  or  other  securities ;  upon  the  syndicating,  banking,  and  other 
financial  arrangements  under  which  such  issues  were  made  and  the 
expense  thereof;  and  upon  the  net  and  gross  earnings  of  such  cor- 
porations; and  shall  also  ascertain  and  report  in  such  detail  as  may 
be  determined  by  the  Commission  upon  the  expenditure  of  all  moneys 
and  the  purposes  for  which  the  same  were  expended.  Fifth:  The 
Commission  shall  ascertain  and  report  the  amount  and  value  of  any 
aid,  gift,  grant  of  right  of  way,  or  donation  made  to  any  such  common 
carrier,  or  to  any  previous  corporation  operating  such  property,  by  the 
government  of  the  United  States  or  by  any  state,  county,  or  municipal 
government,  or  by  individuals,  associations,  or  corporations;  and  it 
shall  also  ascertain  and  report  the  grants  of  land  to  any  such  common 
carrier  or  any  previous  corporation  operating  such  property  by  the 
government  of  the  United  States,  or  by  any  state,  county,  or  municipal 
government  and  the  amount  of  money  derived  from  the  sale  of  any 
portion  of  such  grants  and  the  value  of  the  unsold  portion  thereof 
at  the  time  acquired  and  at  the  present  time,  also  the  amount  and 
value  of  any  concession  and  allowance  made  by  such  common  carrier 
to  the  government  of  the  United  States,  or  to  any  state,  county,  or 
municipal  government  in  consideration  of  such  aid,  gift,  grant,  or 
donation. 

The  amendment  further  provides  that  in  making  their 
report,  the  Commission  shall  show  the  value  of  the  prop- 
erty of  every  common  carrier  as  a  whole,  and  separately 
the  value  in  each  of  the  several  states  and  territories.  Also 
that  the  Commission  shall,  after  completing  the  valuation, 
keep  itself  informed  of  all  extensions  and  improvements 


PUBLIC    UTILITIES  647 

or  other  changes  in  the  condition  and  value  of  the  prop- 
erty of  all  common  carriers,  and  shall  ascertain  the  value 
thereof  and  revise  and  correct  its  valuation. 

The  following  suggestions  for  the  making  of  such  an 
appraisal  are  quoted  from  Henry  Floy's  book  on  "The 
Valuation  of  Public  Utility  Properties." 

Suggested  Procedure:  A  valuation,  to  be  complete  in  the  fullest 
sense,  must  take  into  consideration  not  alone  the  original  cost,  present 
value,  or  cost  of  reproduction  of  the  physical  plant,  but  also  the  in- 
tangible and  non-physical  values,  the  limitations  of  franchise,  as  well 
as  the  market  quotation  of  securities.  To  complete  a  valuation  of  such 
broad  scope,  the  following  method  of  procedure  is  suggested : 

(a)  Obtain  from  the  proper  officials  of  the  company  data,  draw- 
ings, and  specifications  covering  original  construction  as  well  as  later 
additions,  also  lists  of  material  and  supplies,  and  if  available,  a  com- 
plete inventory  of  all  existing  physical  property.  Where  inventories 
are  incomplete,  as  is  usually  the  case,  they  must  be  completed  by  field 
inspection,  and  in  every  case  verified  and  checked.  How  thoroughly  and 
with  what  detail  inspection  may  be  necessary  depends  on  the  thorough- 
ness of  the  appraisal  being  made.  For  example,  test  holes  may  have 
to  be  sunk  in  order  to  verify  information  as  to  excavation,  foundations, 
buried  pipes,  duct  lines,  or  other  subsurface  structures.  The  size, 
quantity  and  condition  of  all  physical  property  must  be  determined. 

(b)  Obtain  available  data  as  to  costs  and  prices  by  examination  of 
corporation  vouchers,  not  only  for  the  period  in  which  the  appraisal  is 
being  made,  but  covering  also  original  cost.  Classify  the  cost  to  dif- 
ferent materials  and  labor,  in  accordance  with  that  method  which  will 
enable  a  convenient  and  easy  comparison  for  the  appraisal  work  in 
hand.  Particular  attention  should  be  given  to  expenditures  during  the 
early  history  of  the  company  covering  items  that  may  properly  be  quali- 
fied as  "Development  Expenses,"  such  as  interest,  taxes,  and  similar 
expenses  during  construction,  checking  the  cost  as  ascertained  from 
vouchers  with  the  book  cost.  The  two  are  not  likely  to  agree,  due  to 
destruction  of  old  records,  accidentally  or  otherwise,  and  the  fact  that 
expenditures  may  have  been  made  and  no  vouchers  received  therefor. 

(c)  Examine  the  record  books  of  the  corporation,  ascertaining 
therefrom  all  information  as  to  the  issuance  of  stocks,  bonds,  or  other 
forms  of  indebtedness,  the  cash  received  therefrom,  records  of  transac- 
tions of  the  officials  in  authorizing  contracts,  and  the  prices  thereof. 

(d)  A  personal  inspection  and  examination  must  be  made  of  a 


648 


AUDITING 


physical  property  by  the  individual  in  charge  of  the  appraisal  work,  and 
a  more  or  less  detailed  acquaintance  had  with  the  plant  and  the  con- 
ditions under  which  it  is  operating,  even  though  the  working  out  of 
detailed  information  is  left  to  one's  subordinates. 

(e)  Determine  the  unit  prices  to  be  used  and  the  percentages  to 
be  allowed  in  connection  therewith;  the  fixing  of  unit  prices  and  per- 
centages to  be  added  depends  upon  the  basis  adopted  for  the  prices 
themselves. 

(f)  Using  the  completed  inventory,  the  unit  prices  determined 
upon  are  to  be  applied  and  the  work  carefully  checked  to  avoid  errors. 
Two  inventories  and  two  sets  of  unit  prices  may  be  necessary  if  both 
the  original  cost  and  the  cost  of  reproduction  are  being  determined. 
To  the  totals  obtained  from  applying  the  unit  prices  to  the  inventory 
should  be  added  the  percentages  for  engineering,  contingencies,  and 
administration  or  superintendence  during  construction,  etc.,  in  order  to 
obtain  the  cost  of  the  physical  plant. 

(g)  If  the  depreciated  or  present  value  is  desired,  the  amount  of 
depreciation  must  be  determined  in  accordance  with  the  principles  laid 
down  in  the  chapter  on  "Depreciation"  and  this  sum  deducted  from  the 
cost,  giving  the  present  value  of  the  physical  plant. 

(h)  Investigate  the  actual  operating  conditions,  method  of  serving 
the  public,  rates  charged,  system  of  providing  for  depreciation,  and 
maintenance  of  the  property. 

(i)  Ascertain  the  limiting  conditions  in  the  articles  of  incorpora- 
tion, charters,  franchises,  municipal  contracts,  or  other  governing  obli- 
gations, determine  whether  local  conditions  are  such  as  to  promise  fair 
treatment  and  a  bright  future  for  the  corporation,  or  whether  its  busi- 
ness is  likely  to  be  interfered  with,  either  through  competition  or 
popular  opposition. 

(j)  Development  expenses  are  determined  from  a  consideration  of 
the  time  necessarily  consumed  in  building  the  plant  under  consideration, 
the  rate  of  interest,  taxes,  and  other  such  expenses,  with  proper  allow- 
ance for  remuneration  to  the  original  promoters  of  the  enterprise. 

(k)  Consideration  should  be  had  as  to  whether  good-will,  fran- 
chise, or  going  value  should  be  allowed  for,  and  if  so,  the  amount  may 
be  determined  from  a  consideration  of  the  matters  set  forth  in  another 
chapter. 

(1)  The  sum  of  the  physical  plant  value  plus  the  development  ex- 
penses, plus  the  value  of  franchise,  good-will,  going  value,  or  contracts, 
if  any,  will  result  in  a  sum  representing  one  fair  value. 

The  items  to  be  determined  in  making  a  valuation  to  ascertain 
the  total  fair  value  of  a  utility  property  may  be  diagrammatically  sum- 
marized as  follows: 


PUBLIC    UTILITIES 


649 


Net  cost  of  physical  plant 
Contractor's  profit 
Engineering 
Contingencies,  etc. 


Expenses  preliminary  to  beginning  plant 

construction 
Overhead  expenses  during  construction 
Working  capital 
Superseded  plant 


Franchises 
Good-will 
doing  value 
Contracts 


Structural  value 


Development  expenses 


Intangible  value 


-    Total  value 


Steam  Railroads 

Taken  as  a  whole,  railroad  accounting  has  probably 
reached  a  higher  degree  of  standardization  of  accounting 
than  any  other  branch  of  industry  or  commerce.  The  uni- 
form reports  called  for  by  the  Interstate  Commerce  Com- 
mission for  the  past  twenty-five  years,  and  the  authority 
which  the  Commission  has  exercised  for  the  past  nine  years 
of  not  only  prescribing  uniform  reports,  but  the  accounts 
to  be  kept,  and  forbidding  any  deviation  from  the  pre- 
scribed classifications,  have  undoubtedly  contributed  to  a 
considerable  extent  to  this  result.  On  the  other  hand,  it 
is  to  be  noted  that  some  of  the  Commission's  instructions 
have  not  been  based  on  sound  accounting  principles.  For 
instance,  the  classification  of  construction  expenditures, 
which  was  in  effect  for  many  years,  permitted  bond  dis- 
count to  be  capitalized  and  charged  to  construction.  The 
latest  classification,  however,  recognizes  the  force  of  the 
accountant's  contention  that  discount  is  nothing  else  than  in- 
terest paid  in  advance  and  consequently  cannot  properly 
be  permanently  capitalized,  and  the  present  classification 
forbids  the  capitalizing  of  discount  on  bonds.  It  is  gen- 
erally admitted  that  the  classifications  now  in  force  are 
based  on  sound  accounting  principles. 


650 


AUDITING 


In  England  one  requirement  of  the  Railways  Act  is 
that  before  a  dividend  can  be  paid  auditors  must  certify 
the  semiannual  accounts.  In  recent  years  the  number  of 
American  railroads  having  their  accounts  audited  by  public 
accountants  has  considerably  increased.  In  time,  no  doubt, 
stockholders  will  insist  more  firmly  on  an  independent  verifi- 
cation of  the  accounts  submitted  by  the  management,  but 
progress  in  this  direction  is  very  slow  indeed. 

As  with  all  public  service  corporations,  one  of  the  most 
vital  points  in  auditing  railroad  accounts  is  to  establish 
the  correctness,  or  otherwise,  of  the  apportionment  of  ex- 
penditures as  between  capital  and  income,  or,  as  it  is  also 
termed,  construction  and  maintenance.  The  true  condition 
of  a  company's  operations  and  finances  has  probably  been 
more  often  concealed  by  either  manipulation  or  lack  of  good 
judgment  in  making  charges  to  capital  accounts  than  in 
any  other  one  way.  In  the  case  of  many  large  railroads 
the  auditor's  problem  of  satisfying  himself  that  the  appor- 
tionment of  expenditures  as  between  construction  and  main- 
tenance has  been  correctly  made,  while  by  no  means  en- 
tirely solved,  is  somewhat  simplified  by  the  fact  that 
construction  work  is  usually  done  under  a  department  other 
than  the  one  charged  with  ordinary  maintenance  work. 

The  prime  consideration  in  connection  with  the  veri- 
fication of  income,  and  the  one  in  which  an  audit  of  rail- 
road accounts  dififers  from  an  ordinary  audit,  is  the  audit 
of  the  trafiic  earnings.  These  fall  into  two  general  classes, 
viz.,  freight  and  passenger.  The  principal  data  from  which 
the  trafiic  earning  accounts  are  built  up  are  the  periodical 
reports  from  station  agents  of  freight  received  and  for- 
warded, tickets  sold,  etc.  Also  of  importance  are  reports 
from  "foreign"  (other)  roads,  train  conductors'  reports 
of  cash  fares  collected,  car  records  showing  the  movement 
of  cars  out  on  foreign  lines  or  foreign  cars  on  the  com- 


STEAM     RAILROADS 


651 


pany's  own  lines.  From  the  last-named  records  are  cal- 
culated the  charge  against  or  credits  accruing  to  foreign 
roads  for  equipment  ''away  from  home."  An  important 
item  of  indirect  income,  i.e.,  a  refund  of  expenses  paid 
out,  consists  of  the  charges  to  other  roads  for  repairs  made 
to  their  cars  while  in  temporary  use  by  the  company  whose 
accounts  are  being  audited.  Shop  reports  are  the  usual 
basis  for  these  charges. 

In  the  case  of  large  railroad  systems  it  is  manifestly 
impossible  for  the  professional  auditor  to  examine  in  any 
reasonable  length  of  time  all  the  original  reports  and  other 
data  which  form  the  basis  of  the  traffic  earning  accounts. 
Also  in  view  of  the  fact  that  almost  every  road  has  a 
highly  organized  auditing  department  whose  duty  it  is  to 
conduct  a  continuous  internal  audit,  it  is  not  necessary  or 
even  desirable  that  he  should  attempt  to  do  so.  The  sys- 
tem in  force  should  be  carefully  studied  to  make  sure  that 
by  its  use  an  effective  check  on  the  station  agents,  ticket 
offices,  and  others  handling  funds  for  the  company's  account 
is  maintained.  Sufficient  tests  should  also  be  .made  by  com- 
parison of  original  reports  with  the  summaries  into  which 
their  various  totals  are  carried,  etc.,  to  assure  the  auditor 
that  the  system  is  being  faithfully  carried  out. 

Reports  from  station  agents,  in  addition  to  forming  the 
basis  of  the  traffic  earning  accounts,  are  of  service  in  cer- 
tifying that  asset  appearing  in  the  balance  sheet  as  "Due 
from  Agents."  Every  agent  makes  a  report,  at  least 
monthly,  of  the  account  between  the  company  and  himself, 
showing  thereon  inter  alia  the  uncollected  freight  bills  and 
the  balance  due  the  company  for  collections  made  but  not 
yet  remitted.  The  balance  due  from  each  agent  per  the 
company's  books  should  be  verified  by  reference  to  the 
agent's  last  report.  Frequently  the  two  will  not  be  in  exact 
agreement  owing  to  remittances  in  transit,  suspense  items, 


652 


AUDITING 


etc.  A  reconcilement  of  the  book  balance  with  the  report 
should,  however,  be  in  evidence. 

The  importance  of  verifying  the  balances  purporting  to 
be  due  from  agents  cannot  be  better  emphasized  than  by 
referring  to  a  case  which  received  wide  attention  in  the 
newspapers  a  few  years  ago.  The  treasurer  of  a  constituent 
company  of  one  of  the  largest  systems  in  the  country  con- 
fessed to  having  embezzled  over  $500,000.  While  a  full 
explanation  of  the  manner  in  which  the  funds  were  ab- 
stracted and  the  defalcation  concealed  for  a  period  of  years 
was  never  made  public,  it  was  stated  in  general  terms  that 
the  treasurer  had  tampered  with  the  agents'  accounts.  It 
would  certainly  seem  that  if  the  internal  audit  of  the  agents' 
accounts  had  been  intelligently  and  faithfully  conducted,  the 
theft  could  not  have  been  concealed  for  any  considerable 
length  of  time.  Had  the  accounts  been  periodically  audited 
by  professional  accountants,  the  embezzlement  would  in  all 
likelihood  either  never  have  begun  or  would  have  been 
detected  before  the  amount  had  reached  large  proportions. 

With  reference  to  depreciation  charges,  it  may  be  stated 
that  the  Interstate  Commerce  Commission  has  made  them 
compulsory  for  equipment,  but  not  for  track  or  structures. 
It  is  still  optional  with  the  railroad  management  whether 
or  not  any  depreciation  at  all  shall  be  charged  for  accruing 
renewals  or  obsolescence  of  track  and  structures. 

The  Pennsylvania  Railroad  Company  sets  aside  for  de- 
preciation, renewals,  and  obsolescence,  3  per  cent  on  freight 
cars  and  4  per  cent  upon  passenger  cars  and  locomotives. 

While  the  railroad  audit  includes  many  other  points, 
some  of  them  of  extreme  importance,  they  are  not  suffi- 
ciently different  from  those  obtaining  in  other  lines  of  busi- 
ness to  call  for  special  treatment  at  this  time. 

Valuable  papers  on  steam  railroad  accounts  were  pre- 
sented by  Professor  Henry  C.  Adams  (connected  with  the 


SHIPPING    COMPANIES 


653 


Interstate  Commerce  Commission)  and  Arthur  W.  Teele, 
C.P.A.,  to  the  Atlantic  City  convention  of  the  American 
Association  of  Public  Accountants.  They  are  to  be  found 
in  the  Association's  1908  "Year  Book." 

The  following  extract  from  an  article  in  a  financial 
paper  summarizes  a  number  of  the  important  points  to  be 
covered  in  auditing  railroad  accounts : 

No  one  doubts  that  the  Bahimore  and  Ohio  of  today  is  a  magnifi- 
cent property.  But  that  is  all  the  more  reason  why  it  should  seem 
very  strange  that  some  of  those  who  are  still  in  the  board  should  ap- 
parently have  forgotten  the  experience  of  sixteen  years  ago.  Early 
in  September  of  1896,  despite  the  profit  and  loss  surplus  of  $23,737,000 
then  existing,  Stephen  Little  was  employed  to  go  over  the  old  Baltimore 
and  Ohio's  books.  Before  the  end  of  that  month  the  announcement 
that  a  receiver  had  been  appointed  for  the  company  came  like  a  bolt 
out  of  the  blue.  In  his  report  Mr.  Little  gave  the  following  causes 
for  the  Baltimore  and  Ohio's  trouble: 

1.  The  inflation  or  overstatement  of  net  income. 

2.  The  mischarge  of  worn-out  equipment  to  profit  and  loss. 

3.  The  capitalization  of  charges  to  income. 

4.  The  capitalization  of  so-called  improvements  and  betterments  of 

leased  lines. 

5.  The  payment  of  unearned  dividends. 

6.  The  understatement  of  liabilities,  etc. 

Shipping  Companies 

Previous  to  191 1  there  was  no  recognized  uniform  classi- 
fication of  accounts  for  shipping  companies.  The  Interstate 
Commerce  Commission  now  provides  very  comprehensive 
classifications  of  accounts  for  carriers  by  water  under  its 
jurisdiction. 

Shipping  company  accounts  do  not  differ  materially  from 
those  used  in  ordinary  commercial  undertakings.  However, 
there  are  some  points  in  connection  with  shipping  accounts 
which  are  of  interest.  It  is  customary  to  arrange  them  so 
that  the  income  and  expenses  of  each  trip  can  be  stated 
separately.     To  each  voyage,  therefore,  its  fair  share  of 


654 


AUDITING 


shore  expenses  must  be  allocated,  besides  a  proportion  of 
such  expenses  applying  directly  to  specific  vessels  but  which 
cover  periods  longer  than  a  single  voyage.  The  ascertain- 
ment of  such  amounts  often  involves  considerable  detail. 

Some  shipping  companies  do  business  entirely  with  ves- 
sels chartered  from  their  owners.  The  many  forms  of 
these  hire-agreements,  or  "charter-parties,"  as  they  are 
called,  make  it  imperative  that  the  auditor  should  carefully 
examine  such  agreements  as  may  still  be  in  force  at  the 
time  of  the  audit. 

The  auditor  should  ascertain  that  all  revenues  from 
freight  traffic  and  passenger  service  have  been  accounted 
for,  also  all  moneys  due  from  the  government  for  mail 
service  and  from  express  companies;  that  all  maintenance 
expenses  have  been  charged  as  such,  and  not  included  in 
the  cost  of  vessels;  that  proper  provision  has  been  made 
for  depreciation;  that  all  liabilities  have  been  provided  for, 
also  any  unearned  income;  that  returns  of  insurance  pre- 
miums due  on  account  of  the  ''laying  up"  of  any  vessel 
have  been  obtained. 

The  Interstate  Commerce  Commission  regulations  dis- 
tinctly require  that  provisions  for  depreciation  of  vessels 
shall  be  made.  In  many  cases  in  the  past  it  was  customary 
not  to  make  provision  for  depreciation.  This  was  especially 
so  with  owners  of  single  ships. 

The  minimum  allowance  for  depreciation  should  be  4 
per  cent  per  annum  on  freight  boats  and  ordinary  pas- 
senger steamers.  On  modern  boats  of  high  speed  and 
expensive  equipment,  5  per  cent  per  annum  should  be 
allowed. 

It  will  be  noted  that  these  rates  do  not  mean  a  life  of 
25  years  and  20  years  respectively,  but  in  the  former  case 
161/2  years  and  in  the  latter  case  14  years,  based  on  the 
investment  of  the  depreciation  fund  to  yield  5  per  cent  per 


! 


SHIPPING    COMPANIES 


655 


annum.    As  the  shipping  companies'  own  bonds  are  usually 
available  at  this  rate,  it  is  a  fair  one  to  use. 

Another  custom  which  has  become  quite  general  is  that 
of  a  company's  providing  its  own  insurance  fund  instead 
of  placing  all  its  insurance  with  underwriting  companies. 
In  such  cases  the  amounts  which  would  be  paid  to  the  in- 
surance companies  are  set  aside  and  a  fund  created  to  take 
care  of  losses  and  damages.  It  is  advisable  that  these 
amounts  should  be  segregated  from  other  funds  and  in- 
vested in  securities  which  have  a  ready  market.  All  re- 
pairs and  replacements  which  were  the  result  of  perils  of 
the  sea  and  the  vessels'  proportion  of  general  averages 
would  be  paid  from  this  fund. 

It  is  quite  obvious  that  only  such  companies  as  own  a 
large  number  of  vessels,  and  can  consequently  distribute 
the  risk,  are  really  warranted  in  carrying  any  part  of  their 
own  insurance.  Even  in  such  cases  it  is  universally  rec- 
ognized that  at  least  a  part  of  each  risk  should  be  placed 
with  outside  underwriters. 

Even  when  the  risk  is  well  distributed,  it  sometimes 
happens  that  the  total  loss  of  a  large  vessel  in  excess  of  the 
outside  insurance  carried  will  be  greater  than  the  amount 
accumulated  in  the  company's  own  insurance  fund.  In  such 
cases  the  question  arises  whether  it  is  proper  to  carry  the 
debit  balance  of  the  insurance  fund  into  the  balance  sheet 
as  an  asset.  It  is  sometimes  argued  that  this  is  legitimate, 
especially  if  the  amount  is  not  so  large  as  to  preclude  the 
possibility  of  its  being  eliminated  by  future  credits  within 
a  reasonably  short  period  of  time.  Such  an  argument  is 
fallacious,  however,  as  the  overdraft  on  the  insurance  fund 
has  absolutely  no  value  at  the  date  of  the  balance  sheet  and 
in  no  way  benefits  future  operations,  which  would  be  the 
only  justification  for  entering  among  the  assets  an  item 
which  has  no  present  value.     If  it  is  desired  to  preserve 


656 


AUDITING 


the  identity  of  the  insurance  fund,  even  though  it  has  been 
exhausted,  the  proper  procedure  would  be  to  show  the 
debit  balance  thereof  in  the  balance  sheet  as  a  distinct  item, 
but  deducting  it  *'in  short"  from  the  Surplus  or  Profit  and 
Loss  account  with  an  appropriate  explanation. 

Electric  Railways 

One  of  the  earliest  attempts  by  an  unofficial  organiza- 
tion to  secure  the  adoption  of  a  uniform  system  of  accounts 
for  any  industry  was  made  in  1898,  when  a  committee  of 
the  Street  Railway  Accountants'  Association  of  America 
(now  known  as  the  American  Electric  Railway  Accountants' 
Association)  prepared  a  standard  classification  of  accounts 
for  street  railways.  Many  street  railway  companies  adopted 
this  classification,  and  it  was  also  prescribed  by  the  railroad 
commissioners  of  a  number  of  states  for  use  in  preparing 
reports  submitted  by  railways  under  their  jurisdiction. 

Several  years  ago  the  Interstate  Commerce  Commission 
issued  a  more  elaborate  classification.  As  this  classifica- 
tion was  devised  in  consultation  with  the  Railway  Account- 
ants' Association,  and  has  since  also  been  made  the  basis 
of  classifications  promulgated  by  state  commissions,  it  is 
largely  taking  the  place  of  the  earlier  classification,  which 
had  done  good  service.  It  should  be  borne  in  mind  that, 
excepting  in  those  states  in  which  commissions  having 
authority  to  prescribe  accounting  systems  for  public  utilities 
have  adopted  the  Interstate  Commerce  Commission's  classi- 
fication, adoption  of  the  latter's  classification  is  obligatory 
only  on  such  railways  as  do  an  interstate  business. 

Even  in  those  classifications  which  differ  from  that  of 
the  Interstate  Commerce  Commission,  it  will  be  found  that 
the  differences  are  more  frequently  in  details  than  in  any 
essentials.  The  grouping  of  the  detailed  accounts  is  well 
nigh  universal  into  the  general  classes  of: 


ELECTRIC    RAILWAYS  657 

Maintenance : 

Way  and  structures 

Equipment 
Conducting  Transportation : 

Power 

Operation  of  Cars 
General  and  Miscellaneous 

The  auditor  will  naturally  familiarize  himself  with  the 
classification  in  use  before  beginning  his  audit. 

The  revenue  of  an  electric  railway  is  largely  on  a  cash 
basis,  the  principal  exceptions  being  sales  of  tickets  to  city 
departments  or  the  post-office  department  or  isolated  cases 
of  very  large  ticket  users  having  recognized  financial  stand- 
ing, advertising  in  cars,  sales  of  scrap  and  other  old  mate- 
rial, and,  in  the  case  of  railways  carrying  freight,  accounts 
with  large  shippers  having  good  credit.  Traffic  sheets  are 
made  up  for  each  day  showing  the  different  runs  and  the 
amount  of  cash  fares,  tickets,  and  passes  turned  in  by  each 
conductor.  The  totals  of  these  sheets  should  be  traced  into 
the  cash  book.  The  traffic  sheets  themselves  should  be 
tested  by  comparing  therewith  conductors'  reports  for  days 
in  different  parts  of  the  period  under  review.  A  further 
test,  which  is  of  a  reciprocal  nature,  is  to  compare  the 
names  of  conductors  on  the  pay-roll  with  the  names  on 
the  traffic  sheets  to  see  that  some  amount  is  entered  on 
the  latter  for  each  conductor  appearing  on  the  pay-roll. 
While  this  comparison  does  not  establish  the  correctness 
of  the  amounts  entered  on  the  traffic  sheets,  it  would  re- 
sult in  the  detection  of  the  total  omission  of  the  receipts  of 
any  conductor.  On  the  other  hand,  it  would  reveal  any 
padding  of  the  pay-roll  as  far  as  conductors  are  concerned. 
Indirectly,  it  also  places  a  check  on  the  number  of  motor- 
men  on  the  pay-roll,  as  these  two  classes  of  carmen  should, 


658 


AUDITING 


of  course,  be  in  a  proper  proportion  to  each  other.  Traffic 
receipts  should  be  in  evidence  for  every  day  in  the  year. 

Receipts  from  ticket  sales  can  frequently  be  verified  in 
total  by  reference  to  the  serial  numbers  of  the  first  and 
last  tickets  sold  during  the  period.  Complications  in  the 
shape  of  tickets  in  the  hands  of  conductors  at  beginning 
and  end  of  the  period  w^ill  sometimes  be  encountered,  but 
these  will  usually  not  interfere  with  verifying  the  ticket 
sales,  at  least  approximately. 

The  earnings  from  advertising  in  cars  and  waiting- 
rooms  are  to  be  verified.  Usually  this  is  not  a  difficult 
matter.  More  often  than  not,  a  contract  for  the  entire 
advertising  space  is  made  with  an  agency  for  a  fixed  sum 
per  annum.  Under  such  circumstances  the  verification  of 
the  income  from  this  source  is  exceedingly  simple. 

Miscellaneous  receipts  from  sales  of  scrap  and  simi- 
lar sources  will  need  to  receive  careful  attention.  As  they 
are  received  at  irregular  times,  failure  to  account  for  them 
could  more  easily  escape  attention  than  in  the  case  of  regu- 
lar traffic  receipts.  All  receipts  of  whatsoever  nature  should 
be  deposited  in  bank.  No  railway  with  a  well-devised  ac- 
counting system  permits  payments  to  be  made  from  traffic 
or  other  receipts. 

The  treatment  of  ticket  sales  in  the  accounts  should 
receive  attention.  Theoretically  the  proceeds  of  tickets  sold 
may  properly  be  included  among  the  traffic  earnings  only 
when  the  tickets  have  been  collected.  Until  that  time  they 
should  appear  to  the  credit  of  an  unearned  or  deferred 
income  account,  which  is  to  be  included  among  the  lia- 
bilities in  stating  the  balance  sheets.  As  the  tickets  are 
sold,  the  receipts  therefrom  are  credited  to  the  liability 
account  referred  to,  and  at  regular  intervals,  say,  monthly, 
transfers  are  made  therefrom  to  the  credit  of  earnings  for 
the  value  of  the  tickets  collected. 


ELECTRIC    RAILWAYS 


659 


In  cases  where  the  ticket  sales  form  a  very  small  pro- 
portion of  the  total  traffic  receipts,  the  outstanding  tickets 
would  be  a  negligible  quantity  and  no  great  harm  will  be 
done  if  tickets  are  treated  as  earnings  when  sold.  With 
many  companies,  however,  the  outstanding  tickets  aggre- 
gate large  amounts,  and  it  is  certainly  not  correct  account- 
ing to  include  among  the  earnings  cash  received  for  service 
which  has  not  yet  been  rendered  to  the  company's  patrons. 
Attention  is  also  called  to  the  fact  that  inaccuracies  in  the 
gross  earnings,  due  to  the  inclusion  therein  of  ticket  sales 
before  the  tickets  have  been  used,  are  greatest  for  some 
time  after  forms  of  tickets  or  methods  of  selling  them  have 
been  changed  or  when  special  tickets  are  sold  for  a  limited 
period. 

As  is  naturally  to  be  expected,  the  most  important  single 
feature  of  the  audit  of  the  expenditures  is  the  verification 
of  the  apportionment  between  capital  and  income.  This  is 
frequently  a  most  difficult  matter,  owing  to  the  fact  that 
the  nature  of  many  of  the  expenditures  is  identical,  whether 
they  be  for  extensions  or  for  maintenance,  i.e.,  they  will 
be  for  materials  and  labor,  and  the  items  on  their  face  do 
not  indicate  conclusively  in  which  category  they  properly 
fall. 

If  a  system  of  recording  construction  and  equipment 
costs  is  in  use,  the  auditor  will  be  able  to  satisfy  himself 
as  to  the  propriety  of  the  construction  charges  much  more 
readily  than  when  such  records  are  lacking.  Unfortunately 
many  companies — probably  a  majority — do  not  have  such 
records.  The  keeping  of  them  does  not,  as  a  rule,  entail 
an  undue  amount  of  work,  and,  where  not  already  in  use, 
the  auditor  should  recommend  their  installation.  The  es- 
sentials are  that  a  separate  account,  usually  in  a  subsidiary 
ledger,  be  opened  for  each  distinctive  piece  of  construction 
work  undertaken  and  for  each  addition  made  to  the  equip- 


66o  AUDITING 

ment.  All  construction  charges  should  find  their  way  into 
this  ledger.  In  the  general  ledger  the  expenditures,  store- 
room charges,  etc.,  would  be  debited  to  a  controlling  ac- 
count called,  say,  "Construction  in  Progress."  As  a  specific 
piece  of  construction  work  is  completed,  the  total  shown 
in  the  account  therefor  in  the  subsidiary  ledger  would  be 
transferred  by  journal  entry  (from  the  Construction  in 
Progress  account  to  the  appropriate  account  or  accounts  in 
the  classification  of  construction  accounts  in  the  general 
books.  Under  this  plan  the  entries  for  charges  to  con- 
struction accounts  show  what  they  are  really  for  and  what 
additions  to  the  company's  roadway,  structures,  or  equip- 
ment have  really  been  made.  The  total  of  the  expenditures 
made  on  uncompleted  construction  work  appears  on  the 
general  ledger  in  the  Construction  in  Progress  account,  and 
the  details  may  be  referred  to  in  the  construction  cost 
ledger. 

Where  construction  records  have  not  been  kept,  the  audi- 
tor will  find  it  necessary  to  consult  with  the  company's 
engineer  and  use  such  other  means  as  are  available  to  get 
definite  information  as  to  just  what  has  been  accomplished 
by  the  expenditures  charged  to  capital  accounts.  Having 
supplemented  in  this  way  the  data  furnished  by  the  books, 
he  will  then  have  to  decide  whether  the  company  was  war- 
ranted in  charging  the  expenditures  against  capital  rather 
than  against  earnings. 

Depreciation  of  plant — or,  if  the  word  "depreciation" 
has  an  unpleasant  sound,  the  term  "accruing  renewals  and 
replacements"  may  be  substituted — is  a  most  important  sub- 
ject in  connection  with  electric  railways.  Up  to  a  few  years 
ago  railway  operators,  and  especially  promoters,  would 
not  admit  that  there  was  any  necessity  whatever  for  the 
inclusion  of  depreciation  charges  in  the  operating  accounts. 
Their  stock  argument  was  that  the  franchises  increased  in 


ELECTRIC    RAILWAYS  66 1 

value  more  rapidly  than  the  physical  property  deteriorated, 
and  consequently  there  was  no  depreciation  in  the  property 
as  a  whole.  The  fact  that  the  increase  in  franchise  values 
would  not  produce  funds  wherewith  to  make  replacements 
when  they  were  finally  needed  was  ignored.  Since  the  re- 
peated puncturing  of  this  fallacy  by  the  bankruptcy  of  com- 
panies which  proceeded  on  such  an  unsound  basis,  railway 
operators  have  reluctantly  come  to  admit  the  necessity  for 
taking  account  of  depreciation,  until  at  the  present  time 
practically  all  engineers  of  high  standing  consider  it  as  an 
item  of  operating  expense.  It  is  a  satisfaction  that  the 
correctness  of  a  principle  for  which  at  one  time  almost  no 
one  but  accountants  contended  has  at  last  been  recognized. 
In  cases  where  companies  have  not  made  any  allowance  for 
accruing  depreciation,  the  auditor  is  not  warranted  in  giv- 
ing a  certificate  unless  it  contains  a  qualification  plainly 
calling  attention  to  the  omission  of  depreciation  allowances. 
Fortunately,  qualified  certificates  are  becoming  unpopular. 
So-called  reconstruction  expenditures,  when  no  depre- 
ciation reserve  has  been  provided  against  which  they  can 
be  charged,  sometimes  present  a  perplexing  problem.  Fre- 
quently they  are  the  result  of  the  omission  over  a  period 
of  years  to  make  renewals  as  they  are  needed,  and  thus, 
when  extensive  expenditures  for  the  rehabilitation  of  the 
property  are  finally  imperative,  they  really  represent  an  ac- 
cumulation of  long-deferred  maintenance  charges.  It  is 
manifestly  unfair  to  charge  the  entire  amount  of  the  ex- 
penditures against  the  operations  of  the  particular  year  in 
which  they  happen  to  be  made.  On  the  other  hand,  if  they 
are  but  accumulated  maintenance  charges,  the  mere  size 
thereof  does  not  justify  capitalizing  them.  Then,  too,  the 
problem  is  usually  complicated  by  the  fact  that  the  expendi- 
tures usually  result  in  some  increase  in  the  carrying  capacity 
of  the  road.     The  worn-out  rolling  stock  is  replaced  with 


662 


AUDITING 


larger  units,  heavier  rails  are  laid,  and  power-plant  equip- 
ment of  increased  capacity  is  installed. 

The  proper  treatment  of  reconstruction  charges  is  to 
charge  to  capital  such  part  thereof  as  represents  an  in- 
creased value  in  the  reconstructed  part  of  the  property  over 
the  original  cost  of  the  property  replaced;  such  part  of 
the  expenditure  as  represents  a  fair  or  normal  annual  main- 
tenance charge  should  be  debited  to  operating;  and  such 
part  as  represents  the  making  good  of  neglected  mainte- 
nance applying  to  prior  years  should  be  treated  as  a  special 
charge  against  profit  and  loss. 

When  such  reconstruction  expenditures  are  made  by  a 
company  after  the  purchase  of  a  dilapidated  property,  it  is 
assumed  that  in  fixing  the  purchase  price  allowance  was 
made  for  the  expenditures  required  to  be  made  to  place  the 
property  in  good  operating  condition.  Consequently,  under 
such  circumstances  the  entire  amount  of  the  reconstruction 
expenditures  is  considered  to  be  a  proper  capital  charge. 
It  is  to  be  borne  in  mind  that  especially  under  such  circum- 
stances it  is  essential  that  depreciation  allowances  be  in- 
cluded in  the  accounts.  Otherwise,  with  the  abnormally 
low  maintenance  expenditures  which  will  naturally  follow 
during  the  first  few  years  after  extensive  reconstruction, 
the  showing  of  net  earnings  will  be  misleading. 

It  should  be  borne  in  mind  that  there  is  danger  in  capi- 
talizing charges  for  betterments  which  do  not  increase  earn- 
ings nor  decrease  operating  expenses.  On  the  other  hand, 
in  view  of  rate  regulation  it  is  not  safe  to  wipe  off  all  such 
expenditures.  The  situation  can  perhaps  best  be  met  by 
capitalizing  the  charges  and  segregating  a  liberal  propor- 
tion of  the  surplus  to  prevent  the  payment  of  unwarranted 
dividends. 

The  liability  for  unsettled  damages  to  persons  and  prop- 
erty always  needs  to  be  thoroughly  investigated.     In  prac- 


ELECTRIC    RAILWAYS  663 

tically  all  cases  some  suits  will  be  found  to  be  under  way 
or  threatened,  and  in  addition,  consideration  should  be 
given  to  all  accidents  for  which  releases  have  not  yet  been 
obtained,  even  though  suit  has  not  been  entered.  Large 
companies  have  a  special  claim  department,  from  which  the 
desired  information  can  be  obtained,  and  for  smaller  com- 
panies a  letter  from  the  company's  attorney  should  be  ob- 
tained stating  all  unadjusted  claims  and  the  probable  cost 
of  settlement. 

Many  companies  create  an  accident  reserve  by  crediting 
to  such  an  account  and  charging  to  operating  expenses  a 
certain  percentage  of  the  gross  earnings.  Payments  in 
settlement  of  claims  are  charged  against  the  reserve.  This 
plan  is  preferable  to  that  of  charging  accident  payments 
directly  to  operating  expenses,  as  it  equalizes  the  charge  to 
successive  fiscal  periods  and,  if  the  charge  is  ample,  creates 
a  reserve  for  those  claims  which  are  unsettled  at  the  end  of 
each  period.  The  plan  must  be  intelligently  used.  Some 
companies  use  too  low  a  percentage  and  carry  the  resulting 
debit  balance  in  the  reserve  account  along  from  one  period 
to  another  as  a  deferred  charge  to  operations.  Obviously, 
payments  for  accidents  occurring  in  one  period  are  not  of 
the  slightest  benefit  to  the  operations  of  a  future  period,  and 
if  a  debit  balance  develops  in  an  accident  reserve  account,  it 
should  be  forthwith  written  off.  Such  a  condition  is  some- 
times due  to  an  unusually  serious  and  costly  accident,  which 
is  not  likely  to  occur  again  soon,  and  it  may  not  be  necessary 
to  raise  the  percentage  of  gross  earnings  credited  to  the 
accident  reserve.  As  already  stated,  however,  the  overdraft 
in  the  reserve  account  should  be  immediately  written  off,  as 
it  is  not  an  asset  in  any  sense  of  the  word. 

The  New  York  Railways  Company  sets  aside  between 
7  and  8  per  cent  of  the  passenger  revenue  for  injury  and 
damage  claims  and  expenses  of  litigation.     The  company 


664 


AUDITING 


has  come  to  the  conclusion  that  it  usually  takes  five  years 
to  liquidate  and  extinguish  completely  all  liability  for  acci- 
dents in  a  given  year. 

The  extensive  development  of  the  interurban  electric 
railway  field  during  the  past  decade  has  resulted  in  condi- 
tions which  in  some  respects  are  perhaps  even  more  analo- 
gous to  those  of  steam  railroads  than  to  those  of  the  city 
electric  railway.  With  considerable  mileage,  a  large  freight 
and  express  business,  graduated  rates  of  fare  for  passenger 
traffic,  etc.,  an  efficient  auditing  department  as  a  part  of  the 
company's  organization  is  a  necessity.  This  department  will 
naturally  audit  the  details  of  the  company's  operations,  and 
the  professional  auditor's  duty  with  respect  to  this  part  of 
the  work  will  ordinarily  be  limited  to  such  tests  and  in- 
vestigation as  will  satisfy  him  that  the  prescribed  system  is 
being  followed  and  that  the  client's  interests  are  safe- 
g^iarded  in  every  way  possible. 

Taxicab  Companies 

In  auditing  a  taxicab  company,  the  procedure  would 
be  much  the  same  as  for  an  ordinary  manufacturing  com- 
pany, excepting  the  verification  of  its  chief  source  of  income 
— the  charges  for  service  rendered. 

The  taxicabs,  as  the  name  indicates,  are  equipped  with 
taximeters.  These  show  both  the  total  mileage  and  the 
revenue  miles,  i.e.,  the  mileage  run  during  the  time  the  cab 
is  carrying  passengers. 

Most  companies  keep  what  is  called  a  master's  sheet  or 
some  record  showing  the  car  number,  the  time  out  and  in, 
and  the  reading  of  the  meter,  both  as  to  revenue  and  total 
miles.  When  the  cab  leaves  the  garage,  the  reading  is 
entered  on  the  sheet,  and  on  its  return,  the  reading  is  again 
taken  and  entered  alongside  of  the  first  or  "out"  reading. 
The  difference  in  the  revenue  miles  reading  represents  the 


TAXICAB    COMPANIES 


66s 


revenue  miles  run  and  has  to  be  accounted  for  by  the  driver 
of  the  cab,  either  in  cash  or  by  proper  evidence  of  having 
carried  a  charge  customer.  With  the  larger  companies 
most  of  the  calls  originate  at  some  hotel  or  at  a  stand  where 
there  is  a  starter  employed  by  the  company.  It  is  the 
starter's  duty  to  determine  whether  or  not  the  customer 
has  an  account,  and  if  so,  he  signs  a  ticket  which  is  given 
to  the  driver,  so  that  the  driver  turns  in  either  cash  or 
tickets  for  all  fares.  By  most  companies  any  shortages  are 
deducted  from  the  drivers'  wages. 

Each  driver  is  provided  with  a  daily  card,  which  should 
show  the  same  mileage  as  the  master's  sheet,  but  in  addition 
gives  the  details  of  the  call.  The  cash  received  from  this 
source  is  entered  in  a  cash-fares  column  in  the  cash  book 
and  the  charges  are  posted  from  the  tickets  to  the  customers 
ledgers,  the  total  being  posted  through  a  journal  to  the 
general  ledger.  In  some  cases  these  charges  are  written 
up  on  sheets,  or  a  journal,  and  posted  to  the  ledgers  there- 
from. 

It  would  not  be  practicable  for  the  auditor  to  check  the 
accuracy  of  all  of  the  entries,  but  a  thorough  test  should  be 
made  for  a  certain  period.  The  total  cash  fares  and  charges 
should  be  checked  with  the  drivers'  cards.  The  mileage 
shown  by  the  drivers'  cards  should  be  checked  with  the 
master's  sheets,  and  the  ''out"  readings  of  the  mileage 
should  be  compared  with  the  *'in"  readings  of  the  previous 
day.  The  latter  is  important,  as  it  would  be  an  easy  matter, 
if  collusion  existed,  for  the  starter  at  the  garage  to  add 
several  miles  to  the  *'out"  readings  or  to  deduct  several  miles 
from  the  "in"  readings,  which,  if  the  driver  used  the  same 
figures  on  his  card,  w^ould  give  him  less  mileage  to  account 
for. 

Many  companies  keep  mileage  records.  Where  this  is 
not  done,  it  w^ould  be  well,  in  connection  with  the  checking  of 


566  AUDITING 

the  master's  sheets,  to  make  a  hst  of  the  mileage,  both 
revenue  and  total,  and  compare  the  ratio  of  the  one  to  the 
other  for  the  period  investigated.  There  are  many  expenses 
which  should  vary  directly  as  the  mileage.  Tires  sometimes 
are  rented  on  a  mileage  basis.  Using  the  mile  as  the  unit 
and  stating  the  earnings  and  expenses  per  mile,  especially 
when  such  results  can  be  compared  with  the  results  of 
another  period,  enables  the  auditor  to  uncover  many  dis- 
crepancies. 

In  the  verification  of  the  pay-rolls,  disbursements,  pur- 
chases, sundry  sales  of  gasoline  and  supplies,  storage,  etc., 
the  procedure  should  be  the  same  as  in  any  other  business. 

Depreciation  is  an  important  item,  but  it  should  be  borne 
in  mind  that  a  good  taxicab  can  be  renewed  in  large  part, 
and  where  tires  and  motors  and  other  repairs  are  being 
charged  against  operations,  a  reserve  of  only  15  to  20 
per  cent  is  sufficient  to  cover  all  depreciation  in  a  going 
concern. 

As  an  illustration  of  the  accounts  to  be  found  in  a  taxi- 
cab  company,  the  following  form  of  balance  sheet  and  state- 
ment of  earnings  and  expenses  is  presented : 

The  Taxicab  Company 

Statement  of  Earnings  and  Expenses 

For  the  Month  of  June,   1915,  and  for  the  Six  Months 
Ended  June  30,  1915 


Earnings 


Six  Months 
Month  of  Ended 

June,  1915        June  30, 
1915 


Motor  Car  Earnings $. 

Miscellaneous  Earnings 


$. 


I 


TAXICAB    COMPANIES  667 


Deductions : 
Refunds  and  Allowances. 


Net  Earnings $ $. 


Expenses 

Vehicle  Operation $ $. 

Garage  Operation 

Maintenance 

Rent  and   Insurance 

Taximeters 

Hired  Equipment 

Licenses 

Commissions    

Free  Riding 

General  Expenses 


% $. 


Reserves : 

Motor  Cars 

Equipment 

Repair  Stock 

Injuries  and  Damages. 

Bad  Debts 

Chauffeurs'  Clothing. . . 


Total   Expenses $ $. 


Current  Operating  Profit: 

Motor  Department $ $. 

Additions  to  Income : 

Interest  on  Deposits 

Discounts  Earned 


Total  Income $ $. 


Deductions  from  Income: 

Interest  on  Bonds $ $. 

Interest  on  Notes 

Discount  on  Bonds 

Organization  Expenses 


Total  Deductions $ $. 


Net  Profit $ $. 


668 


AUDITING 


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670  AUDITING 

Details  of  Statement  of  Earnings  and  Expenses 

For  the  Month  of  June,   1915,  and   for  the  Six  Months 
Ended  June  30,  1915 


Vehicle  Operation: 
Salaries,  Operating  Office 
Chauffeurs'  Wages 
Starters'  Wages 
Gasoline    . 
Lubricants 
Tires 


Garage  Operation: 
Salaries,  Garage  Office 
Wages,  Garage 
Light,  Heat,  and  Power 
Garage  Supplies     . 


Maintenance : 
Body  Repairs,  Labor    . 

"  "        Materials     . 

Chassis  Repairs,  Labor 

"  "        Materials 

Damages  Collected  from  Chauffeurs 
Stockroom  Wages 
Motpr  Car  Accessories 
Chauffeurs'  Clothing    . 
Repairs  to  Equipment 


Rent  an'd  Insurance : 
Rent :, 
Rent  Proportion 
Repairs       " 
Taxes  " 

Insurance  on  Buildings 
Total  Rent 
Insurance  Other  Than  on  Buildings 


Six  Months 
Month  of  Ended 

June,  1915        June  30, 
1915 


TAXICAB    COMPANIES 


671 


General  Expenses: 
Salaries  of  Officers 

General  Office 
Telephone 
Office  Expense 
Stationery 
Postage  . 
Advertising 
Freight  and  Expressage 
Miscellaneous 


Six  Months 
Month  of  Ended 

June,  1915        June  30, 
1915 


$.... 


Results  Per  Unit 


Cabs  used     .... 

Live  miles  run    . 
Dead  miles  run   . 

Total  miles  run 
Percentage  of  live  mileage 
Miles  run  per  cab  for  period 


Drivers'  wages  per  live  mile   . 
Gasoline    per  gross  mile 
Lubricants  "      " 
Tires  "      " 

Chassis  Repairs  per  gross  mile 
Garage  wages  per  cab  used     . 
Garage  supplies  "     "      " 
Body  repairs      "     "      " 

Net  revenue  per  live  mile 

Total  expenses  per  live  mile 
Total  reserve       "      "      " 

Total  cost  per  live  mile 
Current  profit  per  live  mile 






.  $ $ 

$ $ 

$ $ 

$ $ 

6/2 


AUDITING 


Electric  Light  and  Power  Companies 

Classifications  of  accounts  for  electric  light  and  power 
companies  have  been  prescribed  by  a  number  of  states.  The 
Interstate  Commerce  Commission  has  also  issued  a  classifica- 
tion for  use  by  the  electric  companies  in  the  District  of 
Columbia,  which  are  under  its  jurisdiction.  This  classifica- 
tion is  quite  similar,  tq  that  issued  by  the  New  York  Public 
Service  Commissions. 

The  accounting  systems  of  public  service  corporations  of 
different  kinds  have  much  in  common.  The  elements  of  in- 
come from  service  rendered  to  the  public,  the  cost  of  per- 
forming such  service  (made  up  in  turn  of  the  cost  of  main- 
taining the  physical  property  and  the  direct  cost  of  perform- 
ing the  service),  and  the  almost  continuous  expansion  of 
the  plant  to  keep  pace  with  the  growth  of  the  community, 
are  alike  met  with  in  the  case  of  street  railways,  electric  light 
and  power  companies,  gas  corporations,  water  works,  and 
telephone  companies.  Consequently  much  of  what  is  said 
under  each  of  these  classes  of  companies  applies,  sometimes 
with  very  slight  modification,  to  all  classes.  The  remarks 
under  the  general  heading  of  public  service  corporations  are 
also  to  be  considered  in  connection  with  any  one  class  of 
such  corporations. 

Conditions  differ  somewhat,  however,  between  the 
various  classes.  F'or  instance,  while  the  earnings  of  an 
urban  street  railway  accrue  largely  in  cash  from  day  to  day, 
the  earnings  of  an  electric  light  and  power  company  are 
based  on  monthly  charges  to  consumers  who  have  anywhere 
from  five  days  to  a  month  in  which  to  make  payment,  and 
comparatively  little  of  the  revenue  is  on  a  cash  sale  basis. 

The  consumers  register  is  the  initial  record  of  the  gross 
earnings  from  electric  current  sold.  This  record  is  usually 
so  designed  that  it  contains  not  only  the  original  charge  to 
the  consumer,  but  collections  and  credits  for  abatements  are 


ELECTRIC     LIGHT     AND     POWER     COMPANIES 


673 


also  posted  thereto,  and  it  is  in  reality  a  ledger  of  consumers' 
accounts,  and  is  in  fact  called  the  consumers  ledger  in  many 
offices. 

Two  forms  of  consumers  register  are  widely  used.  One 
is  a  wide  columnar  book,  usually  with  one  or  two  short 
leaves,  with  a  group  of  columns  for  each  month,  there  being 
separate  columns  for  balances,  charges,  cash,  and  credits 
under  each  month.  One  or  more  lines  are  allotted  to  each 
customer's  name  or  to  a  location;  the  months  progress 
horizontally  across  the  page.  The  respective  totals  of  bal- 
ances, charges,  cash,  and  credits  (rebates,  allowances,  etc.) 
which  appear  in  the  controlling  accounts  receivable  or  con- 
sumers' account  in  the  general  ledger  are  ascertained  (for 
charges)  or  proven  (for  cash  collections,  credits,  and  bal- 
ances) by  footing  the  column  set  apart  for  each. 

The  other  form  of  ledger  has  but  one  consumer's  account 
on  a  page.  This  also  is  a  book  of  original  entry  as  far  as  the 
charges  are  concerned.  The  totals  of  charges  made,  collec- 
tions posted,  etc.,  are  ascertained  by  scheduling  on  the  add- 
ing machine  items  of  a  given  class  from  all  the  consumers' 
accounts.  The  advantages  claimed  for  the  latter  form  are 
that  it  eliminates  the  necessity  for  carrying  forward,  or  to  a 
recapitulation,  the  totals  of  hundreds  of  pages,  that  a  new 
register  does  not  need  to  be  written  up  anew  each  year  (as 
companies  of  even  moderate  size  will  have  some  thousands 
of  names,  this  is  no  small  task),  and  that  it  permits  of  a 
more  convenient-sized  book  than  the  cumbersome  columnar 
record.  The  individual  account  form,  as  the  last-mentioned 
of  the  two  forms  described  may  be  termed,  is  like  a  sharp 
tool.  In  the  hands  of  a  competent  workman,  it  is  very  use- 
ful, but  in  the  hands  of  any  other,  its  use  may  produce  any 
but  satisfactory  results. 

The  meter-reader's  books  or  cards  are  the  data  from 
which  the  charges  are  made  in  the  consumers  register.     In 


674 


AUDITING 


the  case  of  flat  rates  the  contract  is  the  basis  of  the  memo- 
randum of  the  charge  to  be  made  monthly,  which  is  noted  in 
the  register.  The  best  forms  of  registers  provide  columns 
for  showing  meter  readings.  In  the  wide  columnar  register, 
however,  the  readings  are  not  entered  for  lack  of  space. 
While  the  auditor  is  not  usually  expected  to  go  back  of  the 
charges  in  the  consumers  register,  it  is  well  for  him  to 
avoid  getting  into  a  rut  by  occasionally  comparing  some  of 
the  entries  in  the  meter-reader's  books  with  the  register, 
also  seeing  that  there  are  no  consumers  recorded  in  the 
meter-reader's  books  for  whom  there  are  no  accounts  in 
the  register.  The  monthly  totals  of  charges  for  current  cash 
collected,  etc.,  per  the  consumers  register,  will,  of  course, 
need  to  be  compared  with  the  entries  therefor  in  the  general 
books. 

Sales  of  appliances,  such  as  electrical  irons,  stoves, 
motors,  high  efficiency  lamps,  etc.,  have  become  a  large  item 
in  the  business  of  many  companies.  The  profit  thereon  is 
usually  small.  The  method  of  recording  such  sales  should 
be  carefully  examined,  as  the  misappropriation  of  the  pro- 
ceeds of  such  sales  could  be  more  easily  concealed  than  the 
theft  of  ordinary  collections  for  the  consumption  of  current. 
Sales  of  appliances  are  frequently  made  on  the  instalment 
plan.  The  accounts  receivable  for  uncollected  balances  will 
necessarily  require  thorough  scrutiny.  The  net  profit  only 
from  sales  of  appliances  should  be  included  among  the  gross 
earnings  in  stating  the  company's  operations. 

The  audit  of  the  expenditures  involves  no  features  which 
are  not  common  to  practically  all  public  utilities.  The  dis- 
tinction between  capital  and  revenue  is  of  first  importance. 
The  remarks  made  on  this  subject  under  the  head  of  electric 
railways  are  also  very  pertinent  to  electric  light  and  power 
companies. 

An  unusually  low  ratio  of  operating  expenses  to  gross 


GAS    COMPANIES 


675 


earnings  should  be  the  subject  of  investigation.  In  the  ab- 
sence of  unusual  operating  advantages,  it  is  frequently  due 
to  insufficient  expenditures  for  maintenance,  which  will 
sooner  or  later  result  in  a  rundown  property. 

In  the  case  of  machinery  which  has  a  tendency  to  be- 
come obsolete  as  quickly  as  electrical  equipment  does,  depre- 
ciation allowances  should  be  very  liberal. 

Depreciation  in  electric  light  plants  is  generally  under- 
stood to  be  the  deterioration  in  the  property,  above  ordinary 
repairs,  that  takes  place  because  of  age,  use,  obsolescence,  or 
inadequacy.  On  this  basis  the  depreciation  charge  would  be 
from  4  to  5  per  cent  per  year  on  the  average  cost  value  of 
the  property. 

Gas  Companies 

In  many  respects  the  audit  of  a  gas  company  will  be 
similar  to  that  of  an  electric  light  and  power  company,  which 
has  already  been  considered.  Sales  of  gas  are,  however,  al- 
most invariably  made  on  a  metered  basis,  whereas  fiat  rates 
for  electricity  furnished  have  been  and  are  yet,  although  to 
a  lesser  extent  than  formerly,  quite  common. 

An  item  of  importance  is  the  sale  of  residuals,  particu- 
larly in  the  case  of  companies  manufacturing  coal  gas;  the 
residuals  recovered  in  the  manufacture  of  water  gas  are  less 
in  both  quantity  and  value.  The  quantities  of  residuals  re- 
covered in  different  fiscal  periods  should  be  compared  with 
the  quantities  of  materials  '^charged,"  i.e.,  placed  in  the  re- 
torts, and  explanation  of  variations  in  the  ratio  of  one  to  the 
other  should  be  sought.  The  system  of  recording  and  re- 
porting sales  of  residuals  should  also  be  investigated,  so  as 
to  be  certain  that  failure  to  report  deliveries  to  customers 
will  not  escape  detection. 

Another  important  item  of  income  which  needs  to  be 
verified  is  the  sale  of  appliances.    With  the  largely  increased 


676 


AUDITING 


use  of  gas  for  cooking  and  heating  purposes  which  has  come 
about  in  recent  years,  and  the  energetic  endeavors  of  the 
gas  companies  to  encourage  such  use  to  the  utmost,  it  has 
become  customary  for  the  company  to  sell  stoves  and  other 
appliances  on  the  instalment  plan,  the  payments  covering  a 
period  of  one  to  two  years.  The  business  handled  in  the 
appliance  department  is  frequently  very  large,  the  company 
not  only  selling  the  appliances,  but  also  installing  them.  All 
this  means  that  if  no  loss  is  to  be  sustained,  careless  methods 
must  be  avoided  and  suitable  records  be  kept  of  the  transac- 
tions in  connection  with  the  sales  of  appliances  and  fittings 
and  the  dihgent  prosecution  of  the  collection  of  the  accounts 
or  instalments  as  they  fall  due.  It  is  preferable  to  take  into 
the  statement  of  operations  only  the  net  profit  or  loss  on 
sales  of  appliances,  rather  than  to  include  the  sales  among 
the  gross  earnings  and  the  cost  among  the  operating 
expenses. 

There  are  no  unusual  features  involved  in  the  verification 
of  the  expenditures.  For  the  ordinary  operation  of  the  plant 
the  wages  do  not  usually  fluctuate  very  much.  The  quantity 
of  coal  carbonized,  i.e.,  used  in  making  gas,  should  within 
certain  limits  bear  a  definite  ratio  to  the  quantity  of  gas 
produced. 

Depreciation  of  plant  is  an  especially  important  consid- 
eration in  the  case  of  gas  companies.  Some  parts  of  the 
plant,  particularly  the  retorts  or  benches,  need  to  be  renewed 
at  comparatively  short  intervals.  Hence  full  provision  should 
be  made  for  such  accruing  renewals. 

At  the  1902  annual  meeting  of  the  American  Gas  Light 
Association,  a  committee  appointed  for  the  purpose  of  de- 
vising a  uniform  system  of  accounts  for  gas  works  submitted 
a  report  on  "Classification  of  Operating  Expense  Accounts ; 
Classification  of  Betterments  on  Property  Accounts ;  Forms 
of  Monthly  Journal  Entries  and  Rules  for  Closing."    This 


WATER    COMPANIES 


^71 


furnished  a  working  basis  for  the  classifications  of  accounts 
for  gas  companies  which  have  since  been  issued  by  the  Public 
Service  Commissions  of  the  State  of  New  York  and  the 
Interstate  Commerce  Commission. 

Water  Companies 

The  audit  of  water  companies  is  very  similar  to  that  of 
gas  and  electric  companies.  In  many  companies  a  very  large 
part  of  the  charges  to  consumers  is  based  on  contracts  for 
fixed  annual  rates.  These  rates  are  based  on  a  certain  charge 
for  each  kind  of  plumbing  fixture.  The  use  of  water  meters 
is,  however,  increasing,  especially  by  private  companies 
as  distinguished  from  municipally  owned  water  works. 
Charges  to  consumers  based  on  meter  readings  are  naturally 
treated  in  the  same  manner  as  in  the  case  of  gas  and  electric 
companies. 

Flat  rate  charges  to  consumers  are  most  often  made 
quarterly,  though  in  some  few  cases  they  are  made  monthly, 
and  in  still  other  instances  semiannually,  and — particularly 
in  the  case  of  municipalities — annually.  In  contradistinc- 
tion from  metered  charges,  flat  rates  are  ordinarily  payable 
in  advance,  and  it  is  important  to  see  that  in  closing  the 
accounts  such  part  of  the  flat  charges  as  have  not  yet  been 
earned  are  treated  as  a  liability,  being  carried  forward  as 
deferred  or  unearned  income. 

The  consumers  ledger  accounts  are  usually  arranged  by 
location,  and  as  most  cities  and  towns  are  supplied  by  a 
single  system,  the  accounts  of  buildings  for  which  no  water 
rent  is  charged  should  be  examined  to  see  that  the  water  was 
ofif  during  the  entire  period.  The  dates  on  which  the  water 
is  turned  on  or  off  are  usually  noted  directly  on  the  con- 
sumers ledger. 

In  addition  to  vacancies,  attention  should  be  given  to  ar- 
rearages and  uncoUectable  accounts.    The  bad  debts  should 


5^8  AUDITING 

be  very  small  in  the  case  of  a  well-managed  water  company. 
Unpaid  water  rents  due  a  municipality  are,  in  some  states,  a 
lien  on  the  real  estate  where  the  water  was  used. 

Municipal  ownership  of  water  works  is  far  more  general 
than  is  the  case  with  any  other  class  of  public  utilities.  Prob- 
ably less  attention  has  been  given  to  the  systematic  regulation 
of  water  companies  by  the  states  than  of  other  public  service 
corporations.  This  may  possibly  be  due  to  the  fact  that  so 
many  water  works  are  municipally  owned  and  operated. 
On  the  other  hand,  it  is  to  be  noted  that  there  has  been  much 
litigation  in  attempts  to  regulate  the  rates  charged  by  water 
companies.  Much  of  this  litigation  has  been  the  result  of 
hasty  and  ill-considered  efforts,  superinduced  by  the  heat  of 
political  campaigns. 

None  of  the  state  public  service  commissions  have  pre- 
scribed uniform  classifications  of  accounts  for  water  com- 
panies. The  New  England  Water  Works  Association  has 
for  years,  however,  had  a  form  for  uniform  reports  which 
has  been  used  by  a  considerable  number  of  publicly  and  pri- 
vately owned  water  works.  In  recent  years  the  American 
Water  Works  Association  has  given  considerable  study  to  the 
subject  of  uniform  accounts  for  water  works,  and  in  1907 
the  United  States  Bureau  of  the  Census  began  a  study  of  the 
subject.  As  the  resulj:  of  a  conference  held  at  Washington 
in  1911,  at  which  representatives  of  the  Census  Bureau, 
American  Association  of  Public  Accountants,  American 
Water  Works  Association,  New  England  Water  Works  As- 
sociation, and  others  were  present,  a  suggested  scheme  of 
accounts,  together  with  comprehensive  instructions  for  its 
use,  was  published  by  the  Census  Bureau.  The  pamphlet, 
bearing  the  title  "Uniform  Accounts  for  Systems  of  Water 
Supply,"  may  be  had  on  application  to  the  Bureau  of  the 
Census,  Washington,  D.  C.  The  scheme  of  accounts  has 
been  so  arranged  as  to  make  it  sufificiently  feasible  to  permit 


TELEPHONE    COMPANIES  679 

of  its  adaptation  to  the  accounting  needs  of  both  the  largest 
and  the  smallest  water  works. 

Telephone  Companies 

A  telephone  company's  main  product  is  service.  To  a 
large  extent  the  expense  of  operation  varies  but  little  with 
fluctuations  in  the  volume  of  business  done. 

The  largest  single  item  of  expense  is  that  of  salaries  and 
wages.  In  the  largest  company  this  amounts  to  about  50  per 
cent  of  the  total  income.  Next  is  supplies,  rent,  etc.,  i.e., 
ordinary  operating  expense  outside  of  labor. 

The  disposition  of  the  gross  revenue  of  the  Bell  System 
for  the  year  of  1911,  as  reported  by  the  company,  was  as 
follows : 

Salaries  and  Wages 50% 

Materials,  Rents,  Traveling,  etc 20% 

Taxes  5% 

Interest  and  Dividends 19% 

Surplus 6% 

100% 

In  many  states  some  form  of  jurisdiction  over  telephone 
companies  has  been  given  the  local  public  service  commis- 
sion. On  January  1,  1912,  there  were  twenty-eight  states 
whose  commissions  had  been  given  power  to  regulate  rates 
and  service.  This  fact  plays  an  important  part  in  the  modus 
operandi  of  the  auditor. 

The  assets  of  a  telephone  company  consist  of  its  tele- 
phone plant,  its  contracts  and  licenses,  supplies  and  tools,  ac- 
counts receivable,  cash  and  investments.  Its  liabilities  con- 
sist of  its  outstanding  bonded  indebtedness,  accounts  and 
notes  payable,  and  the  contingent  liability  based  upon  the 
numerous  contracts  with  subscribers  and  others. 

The  income  is  derived  mainly  from  local  telephone 
traffic,  long-distance  tolls,  and  revenue  from  investments. 


68o 


AUDITING 


There  is  often  other  income  in  the  shape  of  rental  derived 
from  property  owned  or  leased,  the  sale  of  scrap  supplies, 
the  charges  for  private  lines  and  special  temporary  installa- 
tions, and  income  derived  from  advertisements  in  the 
directories. 

The  telephone  plant  is  subdivided  into  numerous  ac- 
counts, including  Buildings,  Central  Office  Equipment,  Wire 
Plant,  Construction  and  Equipment,  Substation  Equipment, 
General  Office  Equipment,  Stores  Department  Equipment, 
Utility  Equipment,  etc. 

The  toll  (long  distance)  and  exchange  (local)  business 
must  be  kept  separate,  and  all  expenses  and  income  properly 
apportioned. 

Taxes  constitute  an  important  item  of  expense,  and 
should  be  watched  closely.  The  auditor  should  see  that 
some  adequate  means  of  verifying  tax  bills,  and  providing 
for  taxes  payable,  but  unpaid,  is  in  force. 

The  directories  furnish  opportunities  for  considerable 
peculations  if  not  watched  closely.  The  auditor  conducting 
a  thorough  audit  of  a  telephone  company  cannot  consistently 
certify  to  the  accuracy  of  the  income  without  examining  into 
the  management  of  the  directory. 

The  proper  provision  for  depreciation,  for  the  creation 
of  a  sinking  fund  and  an  amortization  reserve,  when  neces- 
sary, are  questions  that  must  be  settled  in  each  case  accord- 
ing to  the  rules  laid  down  by  the  local  commission,  if  one 
exists;  otherwise  approved  accounting  principles  should  be 
observed. 

An  authority  on  telephone  accounting  has  stated  that 
1.5  per  cent  on  hard  drawn  copper  wire  in  toll  lines,  to  12.5 
per  cent  on  iron  wire  in  exchange  lines,  and  composite  per- 
centages for  complete  plants  varying  from  5  per  cent  to  7 
per  cent  per  annum,  would  be  equitable  charges  for 
depreciation. 


TELEPHONE    COMPANIES  68l 

The  Interstate  Commerce  Commission  has  made  a  regu- 
lation to  the  effect  that  all  additions  to  fixed  capital  are  to 
represent  actual  money  costs. 

The  engineers  making  an  investigation  of  the  rates  of 
a  western  telephone  company  estimated  that  5.14  per  cent 
per  annum  was  a  proper  charge  for  depreciation  and 
renewals. 

The  commercial  department  has  charge  of  public  pay 
stations,  and  to  that  account  are  chargeable  the  salaries  and 
commissions  paid  at  public  pay  stations,  the  cost  of  labor 
and  other  expenses  incurred  in  collecting  from  such  stations, 
the  cost  of  advertising,  and  other  expenses  relating  to  this 
branch  of  the  service.  The  credit  to  the  account  consists  of 
the  toll  received  from  public  pay  stations. 

The  subscribers  ledger  records  the  revenue  of  the  com- 
pany, and  should  be  kept  with  great  care.  It  is  in  the  form 
of  a  journal  ledger,  i.e.,  the  original  charges  are  made  in 
this  book  and  the  totals  thus  shown  are  transferred  to  the 
general  books.  The  book  is  ruled  so  that  it  will  last  for 
one  year  without  rewriting  the  names.  Short  leaves  may  be 
used  to  reduce  the  size  of  the  book.  The  columns  are  headed 
as  follows : 

Telephone  Number 

Name 

Location 

Date  Installed 

Kind  of  Service 

Rate  Per  Month 

Date  Transferred  or  Discontinued 

Each  month's  headings  follow : 

Balance 

Rental 

Toll  and  Messenger  > 


582  AUDITING 

Total  Debit 

Date  Paid 

Amount  Paid 

Rental 

Toll  and  Messenger 

Rebate 

The  toll  and  messenger  charges  should  be  divided  at  the 
end  of  the  month,  as  well  as  the  rebate  for  poor  service  and 
the  bad  debts  written  off.  Two  colors  of  ink  are  usually 
employed  to  mark  the  distinction  in  the  items. 

Depreciation 

The  Railroad  Commission  of  Wisconsin  has  issued  a 
text-book  on  a  system  of  accounting  for  telephone  com- 
panies, which  should  be  consulted  by  those  interested  in 
telephone  accounting.  '  Depreciation  is  covered  by  the  fol- 
lowing instructions : 

Depreciation  Reserve.  This  account  shows  the  balance  set  aside 
for  depreciation  available  for  the  replacing  and  rebuilding  of  the  plant. 
There  is  a  certain  wear  and  tear  taking  place  in  a  plant  which  cannot 
be  made  good  by  ordinary  current  repair,  and  it  is  against  this  that 
the  reserve  for  depreciation  is  made.  The  reserve  shruld  be  made  at 
such  a  rate  as  will  entirely  wipe  out  the  asset  over  the  period  of  its 
probable  life.  It  has  been  held  that  in  a  moderately  large  exchange 
an  allowance  of  7  per  cent  per  annum  is  sufficient  to  take  care  of  all 
depreciations,  but  in  a  small  exchange  an  allowance  of  from  8  to  10 
per  cent  should  be  made.  If  depreciation  is  not  taken  care  of  by  means 
of  a  reserve  fund,  then  the  cost  of  renewing  or  reconstructing  must  be 
charged  to  operating  expense  as  that  work  is  done,  which  has  the 
effect  of  not  providing  proper  comparisons  of  one  year  with  another. 
The  years  in  which  little  reconstruction  work  is  done  show  profits  in 
excess  of  the  actual  profit,  since  no  provision  has  been  made  for  the 
depreciation  or  deterioration  of  the  plant  which  actually  took  place 
during  these  years,  and,  on  the  other  hand,  the  years  in  which  a  great 
amount  of  reconstruction  work  is  required  to  be  done  show  profits 
greatly  short  of  the  actual  profits,  since  the  depreciation  and  deteriora- 
tion of  the  plant  which  took  place  in  earning  the  profits  shown  in 
previous  years  has  been  burdened  on  to  them.     It  is  thus  to  show  the 


TELEPHONE    COMPANIES 


683 


accurate  result  of  the  operations  that  this  account  is  established,  and 
its  operation  is  as  follows : 

At  the  close  of  each  month  this  account  is  credited  and  Account 
No.  76  debited  with  one-twelfth  of  the  yearly  amount  of  depreciation, 
which  is  based  upon  a  fixed  percentage  of  the  amount  invested  in  the 
plant. 

This  account  now  being  set  up  so  that  it  will  exactly  represent  the 
amount  of  the  investment  in  the  plant  when  the  plant  has  been  worn 
out,  it  is  proper  to  charge  against  it  the  net  cost  of  such  renewals, 
replacements,  and  extraordinary  repairs  as  will  increase  the  life  of  the 
plant.    The  net  cost  of  any  such  item  is  arrived  at  as  follows : 

The  original  cost  of  labor  and  material  in  the  part  replaced, 

The  cost  of  removing  same. 

Less  the  scrap  value  of  the  parts  removed, 

this  amount  being  charged  to  Depreciation  Reserve  Account  No.  42 
and  credited  to  the  relative  accounts  as  explained  under  Account  No.  6. 
The  cost  of  the  new  work  is  charged  directly  to  the  appropriate  plant 
account. 

Such  ordinary  current  repairs  as  do  not  necessarily  increase  the 
life  of  the  plant  should  be  charged  to  Maintenance. 

The  depreciation  account  is  not  designed  to  take  care  of  such  con- 
tingencies as  extraordinary  destruction  by  storms,  and  the  cost  of 
repairing  such  damages  is  chargeable  as  follows : 

All  charges  in  connection  with  repairing  the  damage  may  be 
charged  to  Account  No.  31  and  the  scrap  value  of  all  salvage  will  be 
credited  to  this  account. 

When  completed,  an  inventory  of  the  actual  value  of  the  new 
line  should  be  made,  together  with  the  original  value  of  the  line  rebuilt. 

Then  Account  No.  31  should  be  debited  with  the  amount  by  which 
the  original  value  exceeds  the  rebuilt  value  and  Plant  Account  credited, 
or  if  the  rebuilt  value  is  greater  than  the  original  value,  then  Plant 
Account  should  be  debited  and  Account  No.  31  credited  with  the 
amount  of  the  increase. 

An  examination  should  then  be  made  of  the  Depreciation  Reserve 
Account  and  such  sum  as  may  have  been  set  aside  as  depreciation  on 
the  line  rebuilt,  after  deducting  any  amounts  which  may  have  been 
charged  to  Depreciation  Reserve  Account  for  renewals  on  the  rebuilt 
line,  should  be  charged  to  Depreciation  Reserve  Account  and  credited 
to  Account  No.  31. 

When  this  has  been  done,  Account  No.  31  will  show  the  exact 
loss  from  the  storm  and  this  amount  can  then  be  charged  off  to 
Account  No.  11,  either  in  one  sum  or  in  equal  monthly  instalments, 
covering  such  period  as  may  be  decided  upon. 


684 


AUDITING 


The  agitation  for  appraisals  of  public  utility  companies 
has  made  it  necessary  for  telephone  companies  to  keep  more 
detailed  records  of  construction  items.  In  addition  there 
has  been  a  close  scrutiny  of  construction  and  expense 
charges. 

The  following  figures  prepared  by  an  expert  for  the 
New  York  Telephone  Company  as  of  June  30,  1914,  illus- 
trate some  of  the  items  which  would  be  included  by  this 
company  in  its  appraisal : 

Telephone  Plant  (as  per  Tax  Records  revised) $73,889,507 

Plant  in  Service,  but  Bills  Not  Rendered  to  the  Telephone 

Company  300,000 

Liability  Insurance 621,000 

Telephone  Directories,  Library,  Working  Records,  etc 773,068 

Working  Cash  Capital 3,000,000 

Total  $78,583,575 

Overhead  Charges  (Executive  Administration,  Engineering, 

Interest,  Taxes,  etc.) 14,785,000 

Contingencies  and  Omissions 3,694,475 

Training  Operators 678,340 

Selling  Service 2,184,544 

Total    in    New    York    (exclusive    of    "Non-Physical 
Values"  and  of  the  Empire  City  Subway  Company)  $99,925,934 


CHAPTER    XXVI 


I 


J  I 


SPECIAL  POINTS  IN  DIFFERENT  CLASSES  OF 
AUDITS    (Continued) 


MUNICIPAL 

Before  outlining  the  procedure  which  an  auditor  should 
follow  in  auditing  the  accounts  of  a  municipality,  it  will  be 
well  to  outline  briefly  the  methods  by  which  cities  are 
financed  and  to  say  a  word  about  municipal  organization. 

Preparation  of  Budget 

A  time-honored  custom  of  municipalities  and  other  gov- 
ernmental bodies  is  that  no  money  may  be  spent  for  any 
purpose  whatsoever  unless  the  expenditure  has  been  first 
authorized.  This  means  that  revenues  or  other  funds  must 
be  appropriated  for  specific  purposes  by  the  proper  authori- 
ties. The  method  of  authorizing  expenditures  and  appro- 
priating funds  is  usually  provided  for  in  the  city's  charter 
or  by  state  laws.  The  usual  procedure  in  appropriating 
revenues  is  somewhat  as  follows :  Some  time  before  the 
beginning  of  the  fiscal  year  the  mayor  or  chief  financial 
officer  requests  the  head  of  each  department,  bureau,  or 
office  to  prepare  a  detailed  estimate  of  the  amounts  of  money 
that  he  will  require  to  meet  the  expenditure  of  his  depart- 
ment for  the  ensuing  year.  These  estimates  are  usually 
collated  by  the  chief  financial  officer.  In  some  cities  they 
are  examined  by  comparison  with  departmental  records,  as 
they  should  be,  but  in  most  cases  they  are  not.  The  financial 
officer  also  prepares  an  estimate  of  the  revenues  from 
sources   other   than   general   taxes   that   will   probably   be 

685 


586  AUDITING 

received  during  the  ensuing  year,  basing  the  estimate  on  the 
experience  of  previous  years.  These  estimates  of  expendi- 
tures and  revenues  which  constitute  what  is  coming  to  be 
called  the  "tentative  budget"  are  then  submitted  to  the 
council,  board  of  commissioners,  or  other  authorizing  body 
for  action. 

Fixing  the  Tax  Rate 

After  the  amount  which  is  to  be  authorized  for  expendi- 
ture has  been  determined  upon,  the  amount  of  estimated 
revenues  is  deducted  therefrom  in  order  to  ascertain  what 
amount  must  be  raised  by  general  taxation.  This  amount, 
divided  by  the  total  assessed  valuation  of  property,  gives  the 
tax  rate. 

Authorization  of  Expenditures 

These  facts  having  been  determined,  they  are  embodied 
in  an  ordinance,  usually  called  the  budget  ordinance  or 
appropriation  bill,  which  is  voted  by  the  appropriating  body. 
The  charters  of  most  cities  provide  that  the  ordinance  shall 
be  approved  by  the  mayor. 

The  funds  thus  appropriated  usually  provide  only  for 
meeting  the  current  operating  and  maintenance  expenses  of 
the  city.  Funds  for  permanent  improvements  and  other 
property  which  has  a  continuing  value  are  generally  raised 
by  selling  bonds  which  in  most  cases  run  for  a  long  term  of 
years.  These  bond  issues  must  be  authorized  by  the  appro- 
priating body,  and  sometimes  action  by  the  state  legislature 
is  necessary.  Funds  so  raised  must  also  be  appropriated  for 
specific  purposes. 

All  amounts  appropriated  are  represented  by  accounts  in 
the  books  of  account,  and  all  amounts  payable  therefrom  are 
charged  to  them.  The  auditor  should  have  a  copy  of  the 
city  charter  at  hand,  and  before  proceeding  with  the  audit 


MUNICIPAL  587 

should   acquaint   himself   with   the   provisions   relating   to 
finances  and  accounts. 

Business  Departments  of  a  City 

All  cities  except  the  very  small  ones  have  a  finance  de- 
partment and  a  treasury  department,  which  together  handle 
the  general  financial  business  of  the  city  as  a  whole.  The 
most  important  of  these  is  the  finance  department.  This  is, 
or  should  be,  the  central  ofifice  of  financial  and  accounting 
control.  The  official  in  charge  is  sometimes  called  comp- 
troller, sometimes  auditor.  In  commission  cities  he  is  called 
the  commissioner  of  finance,  and  in  the  very  small  cities  the 
functions  of  the  office  are  performed  by  the  city  clerk.  He 
keeps  all  the  general  accounts  of  the  city,  audits  all  claims 
against  the  city  for  payment,  and  performs  such  other  duties 
pertaining  to  the  finances  of  the  city  as  may  be  specified  in 
the  city  charter.     He  is  usually  an  elected  officer. 

The  treasurer  is  sometimes  elected,  but  more  frequently 
he  is  appointed  by  the  mayor  or  the  council.  He  is  custodian 
of  the  city  funds,  receives  all  revenues,  and  pays  all  claims 
against  the  city  on  the  order  or  warrant  of  the  chief  financial 
officer.  His  accounts  should  be  under  the  accounting  con- 
trol of  the  finance  officer,  although  in  some  instances  this 
control  exists  in  name  only.  In  very  small  municipalities 
the  treasurer  frequently  keeps  all  of  the  books. 

The  various  operating  departments  are  managed  by  offi- 
cers, usually  called  either  commissioners  or  directors,  ap- 
pointed in  most  cities  by  the  mayor.  Those  common  to 
nearly  all  cities  are  the  health,  public  safety,  public  works, 
and  public  charities  departments.  There  are  frequently  de- 
partments for  other  functions  according  to  circumstances. 
The  bulk  of  expenditures  is  incurred  by  these  departments. 
Usually  each  has  its  own  purchasing  agent,  although  a  few 
cities  have  central  purchasing  departments.     Most  cities  en- 


588  AUDITING 

deavor  to  make  their  purchases  chiefly  by  letting  contracts, 
though  in  practice  it  is  found  necessary  to  make  many  pur- 
chases in  the  open  market. 

Invoices  and  pay-rolls  are  usually  prepared  for  payment 
on  vouchers  which  are  certified  by  department  heads  and 
their  subordinates  and  submitted  to  the  financial  officer  for 
audit  and  payment. 

Sources  of  Revenue 

The  chief  sources  of  revenue  of  cities  are  the  general 
taxes  levied  annually  on  the  taxable  real  and  personal  prop- 
erty within  the  city.  There  are  many  other  sources  of 
revenue,  among  which  may  be  mentioned  the  following: 

Water  rates 

Excise  taxes  and  liquor  licenses 

Franchises 

Licenses 

Permits 

Privileges 

Rents 

Market  fees 

Market  rents 

Tolls 

Fees 

Court  fines  and  penalties 

Court  costs  and  fees 

Sale  of  old  material 

Interest 

Control  of  Receipts  and  Expenditures 

The  general  theory  of  control  over  city  revenue  is  that 
for  all  moneys  paid  into  the  city  treasury  there  shall  be  an 
independent  report  made  by  the  collecting  office  to  the  finan- 
cial officer,  from  which  he  can  build  up  a  record  of  cash 
receipts  for  the  purpose  of  establishing  a  controlling  account 


MUNICIPAL  689 

against  the  treasurer.  The  means  of  control  over  cash  pay- 
ments made  by  the  treasurer  originate  with  the  financial 
officer,  since  it  is  only  upon  the  order  or  warrant  of  the 
latter  that  the  treasurer  can  pay  out  money.  The  treasurer's 
cash  account  can  be  reconciled  with  the  comptroller's  cash 
account  by  taking  account  of  the  warrants  not  yet  paid  by 
the  treasurer's  cheques.  In  many  cases,  however,  the  treas- 
urer draws  cheques  on  the  same  day  on  which  the  warrants 
are  drawn,  so  that  his  cash  account  is,  or  should  be,  always 
in  agreement  with  the  financial  officer's  account. 

Few  cities  have  adopted  methods  by  which  control  may 
be  established  over  the  amount  of  revenues  that  should  ac- 
crue. This  can  be  done  absolutely  only  by  the  use  of  con- 
trolled financial  stationery*  issued  to  collecting  offices  by 
the  chief  financial  officer.  This  stationery  should  be  so  man- 
ufactured as  to  be  difficult  to  imitate,  and  should  be  num- 
bered and  charged  to  the  collecting  agents,  who  must  account 
for  it  either  in  money  or  unused  forms. 

A  system  should  provide  for  daily  and  monthly  reports 
of  collection,  the  daily  reports  to  the  financial  officer  to  be 
accompanied  by  skeleton  carbon  copies  prepared  at  the  time 
the  original  document  is  issued.  At  the  same  time  daily 
reports  of  collections  are  made  to  the  treasurer,  who,  after 
making  the  necessary  entries  in  his  books,  acknowledges  the 
receipt  of  the  cash  on  the  reports  and  transmits  them  to 
the  finance  officer.  The  latter  audits  the  treasurer's  reports 
by  means  of  the  collecting  agents'  reports  and  the  carbon 
copies  above  referred  to,  thus  establishing  a  current  control 
over  the  accuracy  and  completeness  of  revenue  returns. 

The  accounting  methods  of  most  municipalities  are  crude 
and  archaic,  few  of  them  having  kept  pace  with  the  modern 

•This  is  similar  in  form  to  the  money  orders  used  by  the  post-office  department. 
The  cutting  of  the  dollars  and  cents  on  the  margin  controls  the  amount  to  be 
accounted  for  by  the  receiving  clerk.  The  unused  portion  of  each  piece  of 
stationery  is  preserved  as  a  voucher. 


690 


AUDITING 


improvements  in  accounting  practice.  Their  bookkeeping 
consists  mainly  of  accounts  showing  the  condition  of  appro- 
priation accounts  and  the  inflow  and  outgo  of  cash.  Ac- 
counts on  the  basis  of  revenue  accrued  and  expenses  incurred 
are  the  exception,  and  accounts  showing  assets  such  as  taxes 
and  other  revenue  receivable,  stores,  equipment,  and  other 
permanent  properties,  are  either  not  understood  or  con- 
sidered wholly  superfluous  by  all  but  a  few  cities. 

Periodical  Examinations 

The  following  extract  from  "Short  Talks  on  Municipal 
Accounting  and  Reporting,"  issued  by  the  Metz  Fund, 
August  15,  1912,  is  of  interest: 

As  a  means  of  insuring  continuous  conformity  to  the  authorized 
procedure,  it  is  a  good  plan  to  have  the  accounts  audited  and  the  pro- 
cedure inspected  periodically,  once  or  twice  a  year,  by  a  competent 
representative  of  the  comptroller's  office,  or,  if  necessary,  by  an  outside 
accountant.  In  addition  to  establishing  the  integrity  of  the  accounts 
(if  they  are  correct),  such  an  inspection  will  determine  not  only 
whether  the  procedure  is  being  scrupulously  followed,  but  will  afford 
the  examining  accountant  an  opportunity  to  suggest  modifications  or 
improvements  which  may  be  needed  as  conditions  change  with  the 
lapse  of  time. 

In  this  relation  it  may  be  of  interest  to  quote  from  a  letter  received 
by  the  Metz  Fund  from  the  comptroller  of  a  large  New  England  city. 
He  writes :  "We  are  having  an  audit  conducted  in  this  city  of  the 
comptroller's  records  and  of  other  department  records  in  so  far  as 
they  relate  to  the  comptroller's  records.  Some  criticism  has  arisen  as 
to  the  need  of  such  a  step,  some  maintaining  that  it  is  an  audit  of  the 
auditor  and  that  there  should  be  no  need  for  such  a  proceeding.  While 
I  do  not  expect  you  to  decide  a  controversy,  yet  I  consider  that  a 
talk  on  such  a  subject  would  be  of  interest  to  citizens  and  officials 
throughout  the  country." 

It  is  true  that  many  persons  not  concerned  with  the  active  manage- 
ment of  business  do  not  see  the  necessity  of  an  independent  audit  made 
by  an  outsider.  But  the  experience  of  thousands  of  enterprises  has  so 
conclusively  demonstrated  the  wisdom  of  such  a  procedure  that  the 
subject  is  no  longer  debatable.  A  large  proportion  of  well-conducted 
private  concerns,   even  though  their   regular  office   staff  includes   an 


MUNICIPAL 


691 


auditor  or  a  comptroller,  have  periodical  examinations  of  their  accounts 
made  by  professional  auditors,  and  the  proportion  is  constantly  increas- 
ing. They  have  learned  that  the  moral  effect  of  an  audit  on  the  office 
staff  is  salutary;  that  many  a  man  who,  if  left  to  his  own  devices, 
might  misappropriate  funds  and  falsify  the  accounts  to  conceal  the 
misappropriation,  would  absolutely  be  deterred  from  so  doing  if  he 
knew  that  an  audit  of  the  accounts  would  be  made  which  would  mean 
exposure.  Even  the  employee  who  does  not  have  the  handling  of 
funds  will  do  his  work  better  if  he  knows  that  he  may  be  criticised  by 
an  outsider. 

The  inside  auditor,  from  too  close  contact,  loses  his  ability  as  well 
as  his  disposition  to  criticise,  hence  the  outside  auditor  is  needed  to 
supply  this  deficiency.  The  professional  accountant,  moreover,  by 
reason  of  his  contact  with  the  affairs  and  problems  of  many  widely 
different  concerns,  is  in  a  position  to  make  valuable  suggestions  as  to 
the  accounting  methods,  organization,  and  business  policies  of  his 
client,  and  such  service  has  frequently  bridged  the  gap  between  failure 
and  success.  The  need  for  independent  audits  is  even  greater  in  public 
business,  where  tenures  of  office  are  frequently  of  short  duration  and 
where  there  are  not  the  same  influences  at  work  which  make  for  strict 
accountability  in  private  business.  There  is  no  reason  why  systematic 
audits  of  municipal  accounts  should  not  be  made  by  a  properly  equipped 
state  department. 

Audit  of  Revenue 

The  auditor  should  carefully  examine  the  method  of 
control  over  the  revenues,  and  if  it  is  adequate  in  principle, 
he  should  make  tests  to  satisfy  himself  that  all  the  revenue 
to  which  the  city  is  entitled  has  been  accounted  for.  If  the 
method  of  internal  check  does  not  sufficiently  safeguard  the 
city's  interests,  his  judgment  must  be  guided  by  circum- 
stances. He  must  adopt  such  a  procedure  as  will  be  neces- 
sary to  satisfy  himself  that  the  cash  turned  in  is  the  amount 
collected,  and  that  the  amount  collected  is  the  amount  to 
which  the  city  is  entitled. 

Taxes 

As  general  taxes  constitute  the  major  portion  of  the 
revenues,  he  should  pay  particular  attention  to  the  method 
of  accounting  for  them.     He  should  ascertain  whether  the 


692 


AUDITING 


uncollected  taxes  recorded  on  the  tax  rolls  agree  with  the 
summary  or  controlling  account  in  the  general  ledger.  He 
should  see  that  abatements  made  are  authorized  and  should 
make  tests  to  ascertain  that  the  proper  amount  of  interest 
and  penalties  has  been  collected  on  past-due  taxes.  He 
should  notice  whether  alterations  have  been  made  in  tax 
assessments  in  the  tax  roll  and  should  make  sure  that  all 
alterations  are  authorized. 

The  laws  of  most  states  provide  that  when  taxes  are  in 
arrears  a  certain  length  of  time,  the  tax  liens  (in  some  cases 
the  property  itself)  shall  be  sold  by  the  city  to  indemnify  it 
for  the  taxes  unpaid.  The  auditor  should  make  a  note 
of  all  taxes  in  arrears  in  respect  of  which  the  city  has  not 
availed  itself  of  its  prerogative  thus  to  indemnify  itself. 

Assessments 

Assessments  due  the  city  for  improvements,  such  as 
sewers,  grading  and  paving  streets,  etc.,  benefiting  particu- 
lar properties,  should  also  receive  attention.  In  most  cases 
the  city  undertakes  these  improvements,  financing  them  by 
borrowing  on  public  improvement  or  assessment  bonds  and 
then  assessing  the  property  benefited  to  recover  the  amount 
spent.  Frequently  the  city  bears  a  percentage  of  the  cost. 
The  auditor  should  look  into  the  condition  of  assessments 
levied  to  see  that  they  are  accounted  for  in  cash  or  accounts 
due,  and  whether  the  conditions  attaching  to  the  assessments 
are  being  complied  with,  such  as  the  payment  of  principal 
within  a  stated  period,  interest,  penalties,  etc. 

Rents  and  Franchises 

The  auditor  should  see  that  rents  for  all  properties  of 
which  the  city  is  lessor  are  accounted  for,  and  that  the  in- 
come from  all  franchises  granted  by  the  city  has  been 
accounted  for. 


MUNICIPAL 


693 


Audit  of  Outstanding  Accounts 

The  general  theory  of  verifying  accounts  receivable  by 
sending  confirmatory  statements  to  debtors  may  properly 
be  applied  in  the  audit  of  municipal  accounts.  Such  a  plan 
would  be  particularly  useful  in  verifying  unpaid  taxes,  and 
in  many  cases  would  probably  be  fruitful  of  results,  al- 
though there  will  probably  be  somewhat  more  difficulty  in 
reaching  persons  so  indebted  than  ordinary  trade  debtors. 

Audit  of  Property  and  Equipment 

The  auditor  should  not  neglect  to  audit  the  property  and 
equipment  held  by  the  municipality.  In  many  cities  inven- 
tories are  kept  of  the  property  and  equipment,  and  it  is  a 
simple  matter  to  see  that  the  additions  are  properly  recorded 
and  also  to  ascertain  whether  the  deductions  represent  prop- 
erty sold,  junked,  or  condemned.  It  has  been  said  that 
in  a  large  Eastern  city  a  steam  yacht  worth  $10,000  was 
stolen  and  never  recovered;  in  another  city  an  automobile 
disappeared  mysteriously.  Where  the  city  property  is  not 
completely  inventoried  it  is  the  auditor's  duty  to  see  that 
no  time  is  lost  in  doing  so. 

Audit  of  Expenditures 

The  method  of  internal  audit  of  claims  against  the  city 
should  be  carefully  inspected.  All  vouchers  should  be  ap- 
proved by  the  heads  of  departments  in  which  they  originate 
and  should  be  certified  by  the  subordinates  who  have  knowl- 
edge of  the  facts  as  .to  delivery  of  goods  or  performance  of 
services,  quality,  prices,  correctness  of  calculations,  etc.  If 
vouchers  are  by  law  required  to  be  approved  by  the  council 
or  a  council  committee,  the  auditor  should  see  that  this  rule 
has  been  complied  with.  Payments  of  an  unusual  character, 
such  as  judgments,  damage  claims,  etc.,  should  be  carefully 
scrutinized.    Particular  attention  should  be  paid  to  pay-roll 


694  AUDITING 

vouchers  to  see  that  they  are  not  ''padded."  Usually  the 
salaries  and  number  of  incumbents  of  all  positions  other 
than  those  of  laborers  are  fixed  by  the  council.  Tests  may 
be  made  by  reference  to  the  council's  resolutions  relating  to 
these  matters.  Payments  of  bonds  and  bond  interest  should 
be  carefully  scrutinized  and  audited  by  reference  to  can- 
celed coupons  and  bonds,  or,  in  the  case  of  interest  on 
registered  bonds,  to  the  record  of  bonds  outstanding. 

Tests  of  prices  paid  for  supplies,  particularly  those  used 
in  large  quantities,  such  as  coal,  forage,  etc.,  will  often 
reveal  improper  methods  of  administration.  For  example, 
it  will  sometimes  be  found  that  one  department  buys  coal 
at  one  price  and  that  another  department  pays  the  same  con- 
tractor considerably  more  for  the  same  kind  of  coal  at  the 
same  season  of  the  year.  The  charters  or  ordinances  of  most 
cities  fix  the  maximum  amount  which  may  be  purchased 
on  open  order,  requiring  that  purchases  exceeding  this 
limit  be  made  by  public  letting  of  contracts.  This  rule  is 
frequently  violated  by  "splitting"  orders  among  favored 
dealers,  keeping  each  order  within  the  lawful  limit,  the 
result  of  which  is  that  the  city  pays  very  much  higher  prices 
than  it  would  have  to  pay  if  it  obtained  competitive  bids. 

Since  expenditures  can  be  made  only  from  appropriated 
funds,  the  auditor  should  see  that  claims  have  been  charged 
to  the  proper  appropriation  accounts.  He  should  report  all 
appropriations  which  have  been  overdrawn. 

Sinking  Funds 

The  adequacy  of  sinking  fund  provisions  should  have 
careful  consideration.  It  is  astonishing  how  many  cities 
fail  to  lay  aside  regularly  money  which  will  accumulate  and 
be  sufficient  and  available  to  pay  off  bond  obligations  at 
maturity.  In  order  that  the  burdens  growing  out  of  the 
acquirement  of  properties  of  a  more  or  less  permanent  char- 


MUNICIPAL 


695 


acter  may  be  to  some  extent  distributed  over  a  period  of 
years,  cities  finance  these  acquisitions  by  issuing  long-term 
bonds,  the  plan  being  to  raise  by  taxation  and  set  aside 
each  year  in  a  sinking  fund  an  amount  which,  with  interest 
accretions,  will  be  sufficient  to  retire  the  bonds  at  maturity. 
Rarely  are  these  yearly  sinking  fund  instalments  computed 
correctly;  indeed,  in  some  instances  they  are  not  raised  at 
all. 

In  some  states  the  amounts  which  cities  are  required  to 
pay  into  sinking  funds  yearly  are  fixed  by  law,  a  certain 
percentage  of  the  total  issue  of  bonds  being  specified,  while 
the  charters  of  some  cities  provide  that  revenues  from  cer- 
tain sources  shall  be  turned  into  the  sinking  fund.  Some- 
times this  causes  the  sinking  funds  to  be  in  excess  of  re- 
quirements, which  means  that  taxpayers  are  bearing  a 
heavier  burden  than  is  necessary.  Sinking  fund  require- 
ments should  be  computed  on  the  basis  of  actuarial  tables, 
and  a  reserve  should  be  built  up  by  additions  each  year, 
which  will  at  all  times  show  what  should  be  in  the  sinking 
funds  to  date.  The  auditor  should  ascertain  whether  the 
amounts  in  the  sinking  funds  in  cash  and  securities  equal 
the  actuarial  reserve.  If  there  is  a  deficit  he  should  call 
particular  attention  to  the  fact. 

Financial  Statements 

The  financial  condition  of  a  municipality  is  more  easily 
understood  if  its  transactions  are  summarized  according  to 
the  several  groups  into  which  they  naturally  fall  and  finan- 
cial statements  prepared  accordingly. 

The  accounts  growing  out  of  the  raising  of  current 
revenues  and  the  incurring  of  liabilities  to  meet  current 
operating  and  maintenance  expenses  constitute  the  general 
account,  or  the  general  fund,  as  it  is  frequently  called.  At 
the  end  of  the  fiscal  period  these  transactions  are  reflected 


696 


AUDITING 


in  a  balance  sheet  of  the  general  account  and  a  statement 
of  revenues  and  expenses.  The  assets  and  liabilities  of  the 
general  account  may  thus  be  related  to  a  statement  of 
revenues  and  expenses  as  in  any  private  business.  The 
principal  items  of  assets  are  cash,  taxes,  and  miscellaneous 
revenues  receivable,  stores,  v^ork  in  progress,  and  prepaid 
expenses.  The  principal  liabilities  are  invoices  and  pay- 
rolls payable,  vouchers  and  warrants  payable,  and  temporary 
loans  made  in  anticipation  of  the  collection  of  taxes  and 
other  revenues. 

The  second  natural  division  or  group  has  to  do  with  the 
permanent  properties  and  equipment  of  a  city,  construction 
and  improvements  in  progress,  including  assessments  levied 
against  property  owners  who  are  benefited  by  improvements. 
The  liabilities  relating  to  this  group  are  invoices  and  pay- 
rolls payable,  assessment  or  special  improvement  bonds,  and 
funded  debt.  These  constitute  the  capital  account  balance 
sheet. 

The  third  natural  division  has  to  do  with  the  funds  and 
properties  held  in  trust  by  the  city,  such  as  intestate  estates, 
bequests,  security  deposits,  pension  funds,  etc.  The  condi- 
tion of  these  trusts  is  shown  in  a  trust  fund  balance 
sheet. 

The  fourth  group  comprises  the  appropriation  fund  ac- 
counts, which  are  set  forth  in  a  fund  balance  sheet.  These 
show  the  condition  of  appropriated  funds  and  the  contingent 
liabilities  of  the  city  on  contracts  and  open  orders,  the  latter 
being  charges  or  encumbrances  against  appropriated  funds 
which  have  not  yet  become  actual  liabilities.  Opposed  to 
these  items  are  shown  the  resources,  present  and  prospective, 
which  are  looked  to  for  the  liquidation  of  the  liabilities. 

These  several  detail  balance  sheets  are  brought  together 
in  a  summary  consolidated  balance  sheet  in  order  to  give  in 
a  single  statement  a  complete  view  of  the  city's  finances. 


MUNICIPAL 


697 


General  Account  Balance  Sheet  (Exhibit  2,  page  706) 

Accounts  Receivable — Unpaid  Taxes.  This  is  supported 
by  the  uncollected  items  in  the  tax  rolls,  or  tax  duplicate,  as 
it  is  sometimes  called.  Provision  for  uncollectable  taxes 
should  be  made  currently  by  including  in  the  annual  budget 
of  expenses  a  percentage  of  the  tax  levy  sufficient  to  cover 
the  estimated  loss  in  collection.  The  product  of  taxes  levied 
in  the  year  will  thus  be  sufficient  to  meet  all  expenses  author- 
ized for  the  year. 

Miscellaneous  Revenues  Receivable.  This  account  is 
supported  by  the  revenues  receivable  ledger  and  includes 
various  uncollected  charges. 

Due  from  Other  Funds.  This  account  is  charged  with 
cash  temporarily  loaned  to  the  capital  account  or  to  trust 
funds.  It  is  credited  when  cash  is  returned  or  when  cash  is 
borrowed  from  these  funds. 

Stores  (which  should  be  supported  by  stores  ledgers). 
Are  shown  in  the  general  account  balance  sheet  and  not  in 
the  capital  account  balance  sheet,  since  in  the  main  they  are 
used  for  meeting  current  operating  and  maintenance  ex- 
penses. If  any  stores  are  used  for  construction  purposes,  a 
charge  for  them  is  made  to  the  Capital  account  the  same  as 
if  cash  were  advanced. 

The  reserve  for  stores  among  the  liabilities  is  merely  a 
device  to  keep  them  from  being  represented  in  the  surplus. 
Stores  and  other  prepaid  items  are  not  available  for  meeting 
contingent  liabilities  which  may  exist  or  which  may  be 
incurred  against  appropriated  funds,  and  hence,  to  find  the 
balance  of  assets  available  for  further  appropriation,  they 
are  excluded  from  the  surplus. 

Temporary  Loans  in  Anticipation  of  Taxes.  Many  cities 
are  obliged  to  borrow  money  for  short  periods,  pending  the 
collection  of  taxes  and  other  revenues.  In  consequence, 
temporary  loans  are  made  which  are  a  lien  against  these 


698 


AUDITING 


revenues.    They  should  be  paid  off  when  the  collections  are 
made. 

Capital  Account  Balance  Sheet  (Exhibit  4,  page  708) 

Cash.  Is  held  exclusively  for  meeting  liabilities  incurred 
in  the  acquisition  of  property  having  a  continuing  value, 
such  as  lands,  buildings,  equipment  and  improvements.  It 
is  obtained  by  issuing  long-term  bonds  and  by  the  collection 
of  assessments. 

Assessments  Receivable.  The  amounts  due  from  prop- 
erty owners  whose  property  has  been  benefited  by  local 
improvements,  such  as  the  paving  of  streets,  the  building  of 
new  sewers,  etc.  They  are  frequently  made  payable  in 
instalments.  This  item  is  supported  by  individual  accounts 
in  the  assessment  rolls  or  assessment  ledger. 

Local  Improvements  in  Progress.  Represent  current 
expenditures  for  grading  and  paving  new  streets,  building 
sewers,  etc.,  the  cost  thereof  being  assessable  against  prop- 
erty deemed  benefited  when  the  improvements  are  completed, 
at  which  time  this  account  is  credited  and  Assessments  Re- 
ceivable debited.  Coincident  with  this  entry.  Permanent 
Improvements  account  is  charged  and  Capital  Account  Sur- 
plus is  credited.  It  frequently  happens  that  the  city  is 
obliged  to  stand  some  portion  of  the  cost  of  the  improve- 
ments. This  is  the  case  when  city  property  is  benefited  by 
them  or  when  the  city  at  the  outset  agrees  to  bear  a  per- 
centage of  the  cost.  When  the  city's  share  is  determined, 
long-term  bonds  are  usually  issued  to  meet  it.  At  the  time 
Permanent  Improvements  account  is  charged  as  noted  above, 
Capital  Surplus  is  credited  for  the  amount  assessed  against 
taxpayers  only.  Local  Improvements  in  Progress  being 
credited  with  the  amount  to  be  borne  by  the  city. 

Other  Accounts.  When  among  the  assets,  will  be  readily 
understood  by  their  titles.    These  items  should  be  supported 


MUNICIPAL 


699 


by  detail  ledgers  showing  the  various  individual  properties 
owned  by  the  city. 

The  rule  in  regard  to  depreciation  of  assets  may  be 
applied  in  municipal  accounts  as  in  the  accounts  of  private 
concerns,  with  one  exception.  The  best  authorities  suggest 
that  instead  of  creating  a  depreciation  reserve  by  a  mere 
bookkeeping  entry,  the  depreciation  charges  should  be  in- 
cluded in  the  annual  budget  of  expenses  and  the  cash  raised 
and  invested  in  a  fund.  At  the  end  of  the  period  estimated 
to  be  the  life  of  the  property,  this  fund  would  contain  an 
amount  sufficient  to  replace  it,  and  the  property  would  thus 
be  automatically  perpetuated. 

The  argument  advanced  against  this  practice  is  that  it 
entails  a  double  charge  against  taxpayers,  namely,  the  annual 
depreciation  charge  and  the  annual  sinking  fund  instalments 
provided  for  the  retirement  of  the  bonds  sold  to  purchase 
the  properties.  In  some  cases  at  least,  it  is  a  question 
whether,  when  a  public  work  has  outlived  its  usefulness  and 
an  entire  reconstruction  is  in  order,  there  should  not  be  a 
new  issue  of  bonds  for  the  rebuilding.  In  this  way  the  cost 
of  the  improvement  may  be  spread  over  its  life,  and  each 
generation  of  taxpayers  made  to  bear  the  burden  of  the 
improvements  it  enjoys  by  a  single  charge  for  the  annual 
sinking  fund  instalments.  As  a  matter  of  actual  practice, 
however,  depreciation  of  municipal  properties  is  seldom 
provided  for. 

Assessment  or  Special  Improvement  Bonds.  Represent 
the  bonds  issued  to  finance  assessable  improvements.  They 
are  shown  under  a  separate  head  so  that  they  may  be  con- 
trasted with  assessments  receivable  which  are  available  for 
meeting  them. 

Bonded  Debt.  Instead  of  showing  sinking  fund  cash  and 
investments  among  the  assets  of  the  Capital  account,  they 
are  shown  as  a  deduction  from  bonded  debt.     This  admits 


yOQ  AUDITING 

of  Stating  them  In  a  supplementary  statement  (sinking  fund 
balance  sheet,  Exhibit  5,  page  709)  in  relation  to  the  "Re- 
serve Required  to  Meet  Bonded  Debt  at  Maturity."  As  has 
been  previously  pointed  out,  the  most  important  fact  to  be 
set  forth  in  connection  with  sinking  funds  is  the  amount  that 
should  be  on  hand  in  cash  and  investments  at  any  given 
date.  This  can  be  done  only  by  building  up  a  reserve  on  an 
actuarial  basis,  adding  to  it  each  year  an  amount  equivalent 
to  the  amount  of  cash  that  should  be  provided  each  year, 
which,  accumulated  to  the  maturity  date  of  the  bonds,  plus 
interest  accretions,  will  yield  an  amount  equal  to  the  amount 
of  bonds  to  be  paid  off.  If  an  amount  of  cash  commensurate 
with  the  yearly  reserve  (allowing  for  interest  accretions)  is 
not  provided  each  year,  the  inadequacy  of  the  sinking  funds 
will  be  disclosed  by  the  excess  of  the  reserve  account.  In 
other  words,  there  will  be  a  deficit  in  the  sinking  funds. 

Trust  Fund  Balance  Sheet  (Exhibit  8,  page  710) 

Cash,  Securities,  and  Investments.  Are  supported  by 
detail  ledger  accounts  showing  how  the  trust  funds  are  in- 
vested. The  assets  are  not  necessarily  earmarked  according 
to  the  several  trusts  represented,  though  they  may  be. 

Obviously  the  character  of  the  securities  is  of  importance. 
It  might  be  advisable  to  list  them  on  the  balance  sheet. 

Invoices  Payable,  Vouchers  and  Pay- Rolls  Payable, 
Warrants  Payable.  Are  the  current  liabilities  of  the  trust 
accounts.  The  number  of  separate  general  ledger  accounts 
to  be  kept  will  depend  somewhat  upon  the  precise  methods 
employed  for  handling  transactions. 

Reserve  for  Public  and  Private  Trusts.  Under  this  head 
are  summarized  the  various  trusts  assumed  by  the  city.  Each 
individual  trust  is  represented  by  an  account,  and  if  there 
are  many  of  them,  as  is  usually  the  case  in  large  cities,  these 
accounts  should  be  carried  in  a  subsidiary  trust  fund  ledger. 


MUNICIPAL  701 

Current  Operation  and  Surplus  Account  ( Exhibit  3,  page 
707) 
As  an  adjunct  of  the  general  account  balance  sheet  it 
is  necessary  to  show  ( 1 )  the  revenues  and  expenses  for  the 
fiscal  period,  and  (2)  the  present  condition  of  the  surplus 
of  the  general  account.  Revenues  should  be  summarized 
according  to  sources,  and  expenses  according  to  purposes. 
For  the  latter,  it  is  suggested  that  the  functional  classifica- 
tion adopted  by  the  United  States  Census  Bureau  be  em- 
ployed. This  classification  divides  the  expenditures  of  a 
city  under  the  following  significant  headings,  viz.,  general 
government,  protection  to  persons  and  property,  conserva- 
tion of  health,  sanitation,  highways,  charities,  correction, 
education,  recreation,  interest,  and  miscellaneous. 

The  financial  statements  thus  far  discussed  represent 
what  may  be  called  the  proprietary  relations  of  a  city,  that 
is,  what  the  city  owns  and  what  it  owes  and  the  results  of 
current  operation.  These  statements  are  in  every  respect 
analogous  to  those  employed  in  private  business.  We  shall 
now  discuss  the  statements  that  show  the  funding  relations 
of  a  city,  namely,  those  which  have  to  do  with  the  restric- 
tions placed  upon  public  officers  in  the  expenditure  bf 
funds.  There  are  two  main  categories  of  funds — those  de- 
rived from  taxation  and  those  obtained  from  the  sale  of 
long-term  bonds.  A  statement  of  the  former  is  an  adjunct  of 
the  general  account  balance  sheet,  whereas  a  statement  of 
the  latter  is  an  adjunct  of  the  capital  account  balance  sheet. 

Fund  Balance  Sheet— General  Account  (Exhibit  6,  page 
709) 
An  analysis  of  the  items  appearing  on  the  credit  side  of 
this  statement  will  facilitate  the  understanding  of  it.  When 
the  appropriating  body  authorizes  the  amounts  which  may 
be  expended  (budget),  it  is  necessary  to  establish  accounts 


^02  AUDITING 

in  the  books  so  that  officers  may  know  at  any  time  the 
amount  of  authorized  funds  available  for  expenditure  and 
so  that  they  may  know  when  they  have  reached  the  limit 
of  expenditure.  An  entry  is  therefore  made  in  the  general 
ledger  crediting  "Appropriations"  or  ''Authorizations  to 
Incur  Liabilities"  for  the  amount  authorized.  Detailed  ac- 
counts showing  the  various  purposes  of  expenditure  are 
opened  in  a  subsidiary  ledger.  Under  the  rules  of  double- 
entry  bookkeeping  some  account  must  be  charged,  and  since 
the  appropriations  are  predicated  upon  revenues  which  are 
expected  to  accrue,  an  account  is  established  on  the  debit  side 
entitled  "Estimated  Revenues  from  Taxes  and  Miscellaneous 
Receipts  Needed  to  Meet  Budget  Authorizations."  This 
gives  not  only  a  proper  equation,  but  lays  the  foundation  for 
currently  obtaining  two  distinct  items  of  information,  as  will 
presently  be  shown. 

Some  accountants  attempt  to  treat  appropriations  as  lia- 
bilities and  include  them  among  the  liabilities  in  the  balance 
sheet.  This  is  obviously  improper,  since  the  act  of  appro- 
priating money  for  expenditures  does  not  make  the  city  a 
debtor.  The  argument  in  favor  of  treating  appropriations 
as  a  liability  is,  that  while  a  mere  appropriation  is  not  a 
liability,  yet  if  taxes  have  been  levied  to  provide  for  pay- 
ment of  the  municipality's  expenses  for  a  whole  year  and 
the  uncollected  part  of  such  levy  is  included  in  its  entirety 
among  the  assets,  the  omission  from  the  liabilities  of  the 
appropriations  for  which  the  levy  was  made  shows  a  surplus 
which  is  likely  to  mislead  (at  least  during  the  early  part  of 
the  year)  as  to  the  municipality's  financial  condition.  It  is 
quite  feasible,  however,  by  means  of  the  fund  balance  sheet 
to  show  the  exact  condition  of  affairs  without  thus  doing 
violence  to  the  accepted  meaning  of  terms. 

When  contracts  are  awarded  and  orders  are  issued,  con- 
tingent liabilities  are  created  and  appropriations  are  encum- 


MUNICIPAL  703 

bered.  These  must  be  recognized  in  any  statement  of  a 
city's  financial  condition.  The  details  relating  to  unen- 
cumbered appropriations  and  contingent  liabilities  on  con- 
tracts and  orders  are  shown  by  the  appropriation  ledger 
over  which  these  general  ledger  accounts  operate  as  a  con- 
trol. The  details  of  contracts  in  the  appropriation  ledger 
are  further  supported  by  the  contract  ledger. 

In  order  to  maintain  a  distinct  accounting  action  within 
the  fund  group  of  accounts,  it  is  necessary  to  introduce  two 
other  debit  accounts,  namely,  "Available  Balance"  and  "Un- 
applied Balance."  In  doing  this,  valuable  information  is 
currently  produced  which  otherwise  could  not  be  obtained 
without  analysis.  The  Unapplied  Balance  is  identical  with 
cash  less  demand  liabilities  shown  in  the  general  account 
balance  sheet,  and  as  such  it  shows  what  amount  of  cash  is 
available  for  meeting  contingent  liabilities  on  contracts  and 
orders  already  incurred,  or  to  be  incurred,  against  available 
appropriations.  It  appears  only  in  the  general  ledger  and 
is  not  supported  by  subsidiary  accounts.  Available  Balance 
is  identical  with  accounts  receivable  in  the  assets.  It  is  built 
up  by  credits  to  the  account  "Estimated  Revenues  from 
Taxes  and  Miscellaneous  Receipts  Needed  to  Meet  Budget 
Authorizations."  It  is  likewise  not  supported  by  subsidiary 
accounts.  Action  in  both  of  these  accounts  is  produced  by 
entries  secondary  or  collateral  to  those  which  affect  assets, 
liabilities,  revenues,  and  expenses.  For  example,  when  cash 
is  received  in  payment  of  taxes,  Cash  is  debited  and  Taxes 
Receivable  is  credited.  At  the  time  this  entry  is  made,  a 
secondary  entry  must  be  made  in  the  fund  group  of  accounts 
debiting  Unapplied  Balance  and  crediting  Available  Bal- 
ance. 

The  item  on  the  credit  side  entitled  "Reserve  for  Re- 
tirement of  Loans  in  Anticipation  of  Collection  of  Taxes" 
represents  the  item  in  the  general  account  balance  sheet  en- 


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MUNICIPAL  711 

titled  "Temporary  Loans  in  Anticipation  of  Taxes."     It  is 
not  supported  by  any  subsidiary  accounts. 

For  further  information  regarding  the  bookkeeping  pro- 
cedure relating  to  the  treatment  of  these  accounts,  the  reader 
is  referred  to  ''Handbook  of  Municipal  Accounting,"  pre- 
pared by  the  Metz  Fund  for  Promoting  Efficient  Municipal 
Accounting  and  Reporting. 

Fund  Balance  Sheet — Capital  Account  (Exhibit  7,  page 
710) 
A  similar  group  of  accounts  is  kept  to  show  the  condi- 
tion of  funds  raised  by  issuing  bonds,  and  the  condition  of 
these  funds  is  shown  in  a  fund  balance  sheet  of  the  capital 
account  (Exhibit  7).  One  of  the  items  on  the  credit  side 
of  this  statement  needs  to  be  explained,  namely,  ''Reserve 
for  Retirement  of  Assessment  Bonds."  As  assessments  are 
collected  Assessments  Receivable  is  credited  and  cash  is 
debited.  At  the  same  time  a  secondary  entry  must  be  made 
in  the  fund  accounts  debiting  Unapplied  Balance  and  credit- 
ing this  reserve.  The  latter  serves  to  show  the  cash  that 
should  be  held  available  for  paying  off  the  assessment  bonds 
by  which  the  assessable  improvements  were  financed. 

Summary  Consolidated  Balance  Sheet  (Exhibit  1,  page 
704) 
We  come  now  to  the  summary  consolidated  balance 
sheet,  which  comprises  the  several  detail  balance  sheets  and 
fund  statements  already  described,  and  gives  in  a  single 
statement  a  comprehensive  view  of  a  city's  financial  condi- 
tion. It  is  in  two  sections,  the  first  dealing  with  assets, 
liabilities,  and  surplus ;  the  second  section  showing  estimated 
revenues,  appropriations,  and  reserves.  It  will  be  noted 
that  the  accounts  "Available  Balance"  and  "Unapplied  Bal- 
ance" are  eliminated  from  this  consolidated  balance  sheet, 


^12  AUDITING 

the  assets,  which  they  represent  in  a  detached  statement, 
taking  their  place.  In  the  second  section  the  excess  of  assets 
is  added  to  the  balance  of  "Estimated  Revenues  from  Taxes 
and  Miscellaneous  Receipts,"  for  the  reason  that  appropria- 
tions which  were  predicated  on  such  estimated  revenues  are 
stated  against  them.  As  any  balance  of  the  estimated  rev- 
enues not  accrued  (or  collected)  at  the  end  of  the  fiscal 
year  will  have  to  be  provided  for  in  the  following  year,  it 
must  be  regarded  as  at  least  a  potential  asset.  The  excess  of 
assets  and  estimated  revenues  over  liabilities,  appropriations, 
and  reserves  is  the  amount  which  is  available  for  further 
appropriations ;  in  other  words,  the  free  surplus. 


CHAPTER    XXVII 

SPECIAL  POINTS   IN  DIFFERENT  CLASSES   OF 
AUDITS    (Continued) 


EXECUTORS   AND   TRUSTEES 

An  audit  of  the  accounts  of  executors  or  trustees  prop- 
erly begins  with  a  careful  reading  of  the  will  or  deed  of 
trust,  as  the  provisions  of  these  documents  will  have  an 
important  bearing  on  the  actions  of  the  executors  or  trustees 
as  reflected  in  their  accounts.  While  the  apportionment  of 
receipts  and  payments  between  capital  and  income  should 
always  receive  attention  in  the  auditing  of  trusts,  it  becomes 
extremely  important  under  some  wills  and  trust  deeds. 

Having  examined  the  documents  from  which  the  trustees 
derive  their  power,  the  auditor  should  next  compare  a  cer- 
tified copy  of  the  inventory  of  the  estate,  which  was  filed 
with  a  court  of  probate,  with  the  trustees'  books,  to  see  that 
all  the  assets  scheduled  in  the  inventory  have  been  entered 
in  the  books  and  at  the  appraised  values.  Should  the  trust 
have  already  been  in  existence  for  a  considerable  time  and 
the  audit  not  go  back  to  its  inception,  it  is  desirable  that 
the  examination  start  with  the  date  with  which  the  most 
recent  account  approved  by  the  court  closed. 

The  income  from  securities  should  be  verified  in  detail. 
This  can  usually  be  very  satisfactorily  done;  even  if  the 
securities  are  not  listed  on  a  stock  exchange,  information 
as  to  dividends  or  interest  paid  thereon  can  in  almost  all 
cases  be  obtained  without  much  difficulty.  Overdue  interest 
on  mortgages  should  be  investigated. 

When  examining  the  securities,  which  work  is  an  im- 

713 


^14  AUDITING 

portant  feature  of  the  audit,  the  auditor  should  see  that  they 
are  registered  in  the  names  of  all  the  trustees,  if  there  are 
more  than  one. 

If  real  estate  has  been  committed  to  the  care  of  the 
trustees,  or  if  the  will  gives  the  executors  the  custody  and 
disposition  of  the  testator's  real  estate,  the  rentals  therefrom 
will  need  to  be  verified  and  taxes  and  other  realty  expenses 
vouched. 

Vouchers  should  be  submitted  to  the  auditor  for  all  pay- 
ments. In  verifying  the  correctness  of  the  credits  taken 
by  the  executors  or  trustees,  the  commissions  paid  or  claimed 
should  be  carefully  scrutinized.  Their  arithmetical  correct- 
ness can  usually  be  verified  in  total,  but  it  is  also  important 
to  see  that  the  basis  on  which  they  were  calculated  is  a 
proper  one.  Particularly  must  duplications  of  commissions 
be  guarded  against.  If  an  executor  becomes  trustee  of  an 
estate  after  being  discharged  as  executor,  he  will  receive 
but  one  commission  on  the  principal  of  the  estate.  Further- 
more, a  commission  is  not  ordinarily  allowed  on  changes  of 
investments,  though  it  is  usually  allowed  on  the  net  increase, 
if  any,  in  the  principal  caused  by  such  changes.  The  average 
rates  of  commission  allowed  executors  and  trustees  of  de- 
cedents' estates  are  2j4  or  3  per  cent  on  the  principal  and 
5  per  cent  on  the  income  handled;  but  rates  vary,  and  in 
some  states  a  sliding  scale  of  commissions  is  in  force.  In 
the  case  of  large  estates,  however,  a  different  rate  or  a  fixed 
amount  of  compensation  is  sometimes  named  in  the  will 
(frequently,  no  doubt,  in  pursuance  of  an  agreement  be- 
tween the  executor  to  be  and  the  testator  during  the  latter's 
lifetime),  and  by  accepting  the  trust  the  executor  binds  him- 
self to  limit  his  commission  in  accordance  with  the  stipula- 
tion in  the  will.  Presumably,  however,  if  the  executor  de- 
clined to  serve  and  no  one  could  be  found  who  would  be 
willing  to  accept  the  trust  for  the  stipulated  compensation, 


EXECUTORS    AND    TRUSTEES  715 

the  probate  court  could  appoint  an  administrator  who  would 
not  be  bound  by  this  stipulation  of  the  will,  but  would  be 
allowed  the  ordinary  rate  of  commission. 

The  commissions  allowed  in  New  York  State  are  as 
follows :  on  the  principal  for  receiving  and  paying  out  all 
sums  of  money  not  exceeding  $1,000,  at  the  rate  of  5  per 
cent ;  for  receiving  and  paying  out  any  additional  sums  not 
in  excess  of  $10,000,  2^/2  per  cent;  and  for  all  amounts 
above  $11,000,  1  per  cent.  The  annual  charge  on  income 
is  at  the  same  rate. 

In  a  complete  audit  of  the  accounts  of  a  trust  estate,  the 
investments  made  by  the  trustees  should  also  be  reviewed 
from  the  standpoint  of  whether  they  were  legitimate  at  the 
time  they  were  made.  The  character  of  investments  which 
are  legal  for  trust  funds  vary  in  different  states;  generally 
they  are  first  mortgages  on  real  estate,  government  (federal, 
state,  county,  and  municipal)  bonds,  and  the  first  mortgage 
bonds  of  railroads  having  an  established  dividend  record. 

The  importance  of  a  correct  apportionment  of  all  re- 
ceipts and  payments  between  principal  and  income  has  al- 
ready been  mentioned.  In  this  connection  it  should  be  borne 
in  mind  that  interest  and  rents  accrued  to  the  date  of  the 
testator's  decease  are  part  of  the  corpus  or  principal  of  the 
estate ;  that  profits  realized  or  losses  sustained  on  the  liqui- 
dation of  legitimate  investments  are  added  to  or  deducted 
from  the  principal;  that  expenses  during  the  period  of  the 
executorship  are  paid  out  of  principal  and  not  from  income, 
excepting  expenses  connected  with  improved  real  estate 
which  are  chargeable  against  the  income  derived  therefrom ; 
that  losses  on  unauthorized  or  illegal  investments  are  charge- 
able to  the  trustees  personally,  with  such  interest  (usually 
at  the  rate  of  6  per  cent  per  annum  without  compounding) 
as  may  be  directed  by  the  court ;  that  a  trustee  is  similarly 
chargeable  with  interest  on  funds  actively  applied  to  his 


7i6 


AUDITING 


own  use  or  indirectly  so  applied  by  merging  them  with  his 
own  funds,  even  though  he  may  have  balances  on  deposit 
to  his  personal  credit  in  excess  of  the  trust  funds  for  which 
he  is  responsible;  that,  even  when  investments  of  a  wasting 
nature  are  specifically  authorized,  or  form  the  original  prin- 
cipal of  the  estate,  a  life  tenant  does  not  necessarily  receive 
the  entire  gross  income.  When  the  instrument  creating  the 
trust  provides  that  the  life  tenant  and  the  remainderman  shall 
benefit  equally  from  such  investments,  it  is  usual  to  treat 
such  part  of  the  receipts  from  the  investment  as  equals,  say, 
5  per  cent  on  the  appraised  value  of  the  investment  at  the 
time  the  trust  was  created,  as  income  for  the  life  tenant,  and 
to  capitalize  the  amount  received  in  excess  thereof. 

The  proceeds  from  the  sale  of  rights  given  to  stock- 
holders to  subscribe  for  new  stock  at  less  than  its  market 
value  belong  to  the  principal.  The  additions  to  the  principal 
from  such  sales  are  generally  offset  by  a  reduction  in  the 
value  of  the  old  stock. 

The  terms  of  the  will  or  trust  deed  may,  however,  modify 
any  of  the  foregoing  rules,  and  hence  the  importance  of  the 
auditor  studying  carefully  the  conditions  of  the  trust. 

With  regard  to  premiums  paid  on  securities  purchased 
by  the  estate,  the  usual  rule  is  that  they  come  out  of  the 
principal  of  the  estate.  Discounts  on  bonds  purchased  inure 
to  the  benefit  of  the  principal.  As  probably  the  great  ma- 
jority of  investments  which  are  legal  for  trust  funds  sell 
at  a  premium  rather  than  at  a  discount,  one  does  not  offset 
the  other.  From  an  accounting  standpoint,  premiums  paid 
on  bonds  purchased  should  be  amortized  over  the  life  of 
the  bonds,  and  a  portion  of  each  interest  payment  retained 
to  refund  the  premium  advanced  from  the  principal  of  the 
estate,  and  only  the  actual  income  yield  on  the  investment 
paid  over  to  the  life  tenant.  The  accountant  must,  however, 
in  this  as  in  all  matters  pertaining  to  trust  estates,  be  guided 


EXECUTORS    AND    TRUSTEES  717 

by  the  rules  laid  down  by  the  court,  which  are  not  uniform 
in  the  different  states.  It  is  to  be  hoped  that  the  courts 
will  in  time  give  effect  to  a  more  logical  treatment  of 
premiums  on  bonds  than  they  have  in  the  past. 

The  division  or  partition  of  an  estate  is  frequently  quite 
a  complex  proceeding.  An  estate  is  sometimes  left  in  trust 
for  the  children  of  a  family,  each  to  receive  his  or  her  re- 
spective share  of  the  principal  on  attaining  a  specified  age. 
Until  such  time  each  beneficiary  receives  only  his  or  her 
share  of  the  income.  As  the  specified  event  would  not  occur 
simultaneously  in  the  case  of  all  the  beneficiaries,  they  would 
not  all  become  entitled  to  their  respective  shares  at  the  same 
time.  As  soon,  however,  as  any  one  became  entitled  to  re- 
ceive his  share,  he  could  demand  it  without  having  to  wait 
for  such  time  as  all  the  heirs  could  receive  their  respective 
shares  of  the  principal,  and,  excepting  by  consent,  the  estate 
would  have  to  be  forthwith  divided.  Should  the  estate  con- 
sist of  securities  which  are  readily  divisible,  no  serious  diffi- 
culty is  encountered,  as  the  beneficiary  may  then  be  given  his 
proportion  of  each  of  the  estate's  investments.  Should  the 
estate,  however,  consist  of  real  estate  or  other  non-divisible 
assets,  resort  must  be  had  to  some  other  method  of  deter- 
mining the  beneficiary's  share  and  delivering  it  to  him. 

Were  all  the  beneficiaries  of  age,  a  mutual  agreement 
could  be  made,  but  if  any  one  of  the  beneficiaries  is  a  minor, 
he  or  she  cannot  give  binding  consent  to  such  an  agreement. 
The  only  course  left  open  is  to  apply  to  the  courts  for  an 
order  to  "partition"  the  estate ;  the  final  order  of  the  court 
confirming  the  share  determined  to  be  payable  to  the  bene- 
ficiary entitled  to  the  partition  will  be  a  protection  to  all 
parties  interested.  The  payment  of  his  share  to  the  retiring 
beneficiary  forthwith  terminates  his  interest  in  the  estate, 
and  he  is  not  concerned  in  any  fluctuations  in  the  value  of 
the  trust  investments  which  may  subsequently  take  place. 


7i8 


AUDITING 


Such  fluctuations  would  affect  only  the  remaining  benefi- 
ciaries, for  whose  benefit  the  balance  of  the  estate  would  be 
administered. 

A  principle  of  law  which  should  not  be  overlooked  is 
that  no  beneficiary  who  is  under  age  has  power  to  consent 
to  any  changes  in  the  terms  of  a  trust. 

INSTITUTIONAL 

Educational  Institutions 

As  the  greater  portion  of  the  income  of  educational  in- 
stitutions is  usually  derived  from  tuition  fees,  dormitory 
rents,  and  board,  any  failure  of  the  records  to  control  ade- 
quately the  collection  of  such  income  should  be  reported, 
and  detailed  tests  should  be  made  (if  these  records  are  kept 
by  single  entry)  to  ascertain  that  all  such  income  is  being 
received  and  accounted  for.  Particular  attention  should  be 
given  to  cases  where  no  tuition  fees,  or  fees  at  reduced 
rates,  are  received,  to  ascertain  that  proper  authority 
therefor  has  been  granted.  The  collection  of  extra  charges 
for  diplomas,  special  examinations,  laboratory  or  school 
supplies,  etc.,  should  be  given  careful  attention. 

The  examination  of  securities  and  the  verification  of  the 
income  therefrom  are  important.  The  records  should  show 
clearly  the  total  amounts  of  all  special  funds,  the  invested 
and  uninvested  portion  thereof,  and,  in  addition,  should  en- 
able the  auditor  to  ascertain  that  the  income  therefrom  has 
been  applied  to  the  purpose  designated  by  the  donors. 

The  annual  report  will  be  of  material  assistance  to  the 
auditor  in  the  verification  of  income  from  tuition  and  dona- 
tions, as  the  names  of  students  and  donors  (and  the  nature 
and  amount  of  donations)  are  usually  detailed  therein.  If 
the  report  is  not  published  until  after  the  audit,  it  is  desir- 


CHARITABLE    ORGANIZATIONS  719 

able  for  the  auditor  to  verify  the  proof  sheets  of  the  annual 
report  prior  to  the  final  printing  thereof. 

The  accounts  of  most  educational  institutions  are  kept 
only  on  a  cash  basis,  and  uncollected  income  and  outstand- 
ing liabilities  are  usually  ignored  in  stating  their  financial 
operations.  It  would  be  well  for  the  auditor  to  recommend 
changes  in  the  accounting  records  which  will  enable  accurate 
statements  of  operations,  as  well  as  of  assets  and  liabilities, 
to  be  prepared  periodically.  These  statements  will  be  valu- 
able to  the  executive  officers  and  trustees  and  should  form 
part  of  the  annual  report. 

Charitable  Organizations 

This  class  of  institutions  includes  hospitals,  asylums,  or- 
phanages, relief  societies,  and  all  organizations  whose  aim 
is  to  relieve  suffering  and  distress.  That  respect  in  which 
the  accounts  of  charitable  organizations  especially  differ 
from  ordinary  commercial  accounts  is  the  receipt  of  volun- 
tary subscriptions  and  contributions.  The  receipts  or  ac- 
knowledgments sent  to  contributors  should  be  consecutively 
numbered,  and  preferably  so  designed  that  a  carbon  copy 
will  remain  on  file.  Entries  should  be  found  in  the  cash 
book  for  all  donations  appearing  on  the  copies  of  acknowl- 
edgments to  contributors.  The  only  practical  way  of  in- 
suring an  accounting  for  all  contributions  received  is  to  in- 
clude in  the  annual  report  a  list  showing  both  the  names  of 
contributors  and  the  amounts  of  their  donations;  then  if  any 
donations  have  not  been  accounted  for,  the  donors  may  call 
attention  to  the  omission  of  their  donations  from  the  pub- 
lished list. 

In  hospitals,  asylums,  and  like  institutions  considerable 
income  is  received  from  pay  patients.  This  should  be 
thoroughly  verified.     Keeping  a  controlling  account  in  the 


^20  AUDITING 

general  ledger  for  the  patients'  accounts  will  aid  materially 
in  verifying  the  correctness  of  the  income  from  patients. 

Patients'  accounts  are  similar  in  theory  to  those  of  hotel 
guests.  There  is  a  patients  register  in  which  are  recorded 
the  arrival  and  departure  of  patients,  and  the  books  can  be 
so  arranged  as  to  permit  of  a  conclusive  audit. 

Another  item  of  income  is  from  appropriations  made  by 
the  state.  These  are  sometimes  in  round  sums  and  in  other 
cases  are  based  on  the  number  of  patients  cared  for  at  a 
fixed  amount  per  patient. 

In  some  states  the  accounts  of  charitable  institutions  re- 
ceiving state  aid  are  subject  to  audit  by  representatives  of 
a  state  bureau.  These  official  audits  are  usually  restricted 
to  an  inquiry  into  the  expenditure  of  the  state  appropriation 
and  do  not  embrace  the  verification  of  other  items  of  income 
and  expenditure.  Some  states  also  prescribe  a  classification 
of  expenses  which  institutions  receiving  state  aid  must  fol- 
low, but  these  classifications  have  not  as  a  rule  been  planned 
with  the  thoroughness  characteristic  of  the  classifications 
prescribed  for  public  service  corporations. 

In  the  great  majority  of  cases  the  accounts  of  charitable 
institutions  are  kept  on  a  purely  cash  basis.  The  need  for 
keeping  and  stating  the  accounts  on  a  true  income  and  ex- 
pense basis  so  that  actual  results  of  operations  may  be  seen, 
is  just  as  great  in  the  case  of  charitable  institutions  as  in 
business  houses.  As  every  accountant  knows,  a  cash  state- 
ment does  not  necessarily  show  the  real  cost  of  conducting 
an  institution,  and  a  large  deficit  may  be  accruing  of  which 
the  published  reports  give  no  intimation. 

In  auditing  the  disbursements,  the  actual  cost  of  opera- 
tion should  be  ascertained  as  closely  as  feasible  and  the  per 
capita  cost  determined.  This  will  furnish  data  for  com- 
parison with  the  operations  of  other  institutions  of  like 
nature ;  such  comparisons  make  for  increased  efficiency. 


CHARITABLE    ORGANIZATIONS 


721 


The  use  made  of  trust  funds  devised  to  an  institution 
for  specific  purposes  should  receive  the  auditor's  attention. 
If  the  income  from  the  funds  is  not  being  applied  to  the 
objects  designated  by  the  donors,  or  if  the  principal  of 
funds  has  been  encroached  upon  when  only  the  income  w2ls 
to  have  been  used,  it  is  clearly  the  auditor's  duty  to  call 
attention  to  the  matter. 

These  organizations  frequently  take  care  of  persons  sent 
to  them  by  cities,  counties,  etc.,  in  which  cases  the  cities, 
counties,  etc.,  pay  a  stipulated  amount.  In  other  cases 
charitable  organizations  have  special  accommodations  for 
persons  who  have  sufficient  means  to  pay  for  them.  The 
auditor  should  ascertain  that  the  rates  charged  in  such  spe- 
cial cases  are  based  on  the  cost  of  such  services.  Charitable 
institutions  have  in  some  instances  been  known  to  handle 
these  special  cases  at  a  loss  because  of  the  lack  of  proper 
records. 

The  Subscriptions  Investigations  Committee  of  the  Chi- 
cago Association  of  Commerce  in  a  report  on  their  investi- 
gations of  charitable  and  philanthropic  institutions  said  in 
part : 

The  Committee  regards  it  as  of  fundamental  importance  that  every 
charity  receiving  indorsement  should  have  its  accounts  audited  by  a 
public  accountant.  During  the  past  year  fifty  organizations  have  had 
their  accounts  so  audited  for  the  first  time  in  their  history. 

The  audit  report  contains  detailed  information  relative  to  source 
of  income,  purpose  for  which  funds  are  expended,  assets  and  liabili- 
ties, together  with  a  statement  made  by  the  auditor  as  to  whether 
the  methods  employed  in  the  system  of  accounting  are  satisfactory  and 
up  to  date.  The  audit  also  covers  questions  as  to  the  status  of  in- 
surance matters  and  as  to  whether  the  premiums  have  been  fully  met. 

The  experience  of  the  Committee  with  regard  to  a  public  ac- 
countant's audit  has  strengthened  the  conviction  that  the  audit  is  ab- 
solutely necessary.  Lax  methods  have  been  discovered  and  frankly 
called  to  the  attention  of  the  boards  of  directors  of  institutions 
concerned. 


722 


AUDITING 


The  Comptroller  of  the  City  of  New  York  requires 
charitable  institutions  which  receive  public  aid  to  keep  uni- 
form accounts,  and  to  submit  to  him  periodical  reports,  using 
the  following  forms : 

Comparative  Balance  Sheet  and  Summary  of  Income 
AND  Expenses 

Of 

For  Six  Months  Periods  Ending 19.  .  . . 

Balance  Sheet 


Assets 

Cash  on  Hand  and  in  Bank     .     . 

Due  from  City  of  New  York  . 

Other  Accounts  Receivable     . 

Investments 

Accrued  Income  on  Investments  . 

Inventory  of  SuppHes    .     .     .     . 

Special    Funds 

Real  Estate  and  Buildings,  Do- 
nated         

Real  Estate  and  Buildings,  Pur- 
chased      

Equipment 

Prepaid   Items 

Total  Assets   .     .     .     .     . 


Six  Months  Six  Months 

Ended.  . . .    Ended.  . . .  Increase      Decrease 


$ $ $ 


Liabilities 

Accounts  Payable 
Loans    Payable     . 
Accrued  Items 
Mortgages  Payable  . 
Bonds   Outstanding. . . 


Due. 


^ 

$ $ $ 

Total  Liabilities 


$. 


CHARITABLE    ORGANIZATIONS 


I^Z 


Six  Months  Six  Months 

Ended ....   Ended ....  Increase      Decrease 


Excess  of  Assets  Over  Liabilities    $ $ $ $. 


Surplus  and  Reserves 

Surplus  at  Beginning    .     . 
Income 


.     Total 

Less : 

Maintenance  Expenses    . 
Non-Maintenance   Expenses 

Total 

Surplus  at  End 

Reserves,  for  Special  Funds     . 

Surplus  and  Reserves    . 


? ? $ ? 


$.... 

..  $.... 

..  $.... 

•  .  $ 

$.... 

..  $.... 

..  $ 

$.... 

..  $.... 

..  $.... 

..  $ 

$.... 

..  $.... 

..  $.... 

..  $ 

$.... 

..  $.... 

..  $.... 

..  $ 

Statement  of  Income  and  Expenses 


Income 

New  York  City  for  Maintenance 
New  York  City  for  Education 
Donations,    Gifts,    etc.,    for    Gen 

eral  Purposes 

Donations,  Gifts,  etc.,  for  Special 

Purposes       .     .     . 

Collections 

Fairs,   Entertainments,   etc. 
Sales  of  Manufactured  Products 
Legacies,  Bequests,  etc. — General 
"  "  "  — Special 

Income   on   Investments 
Interest  on  Trust  Funds     .     . 

Rents 

Miscellaneous 

Total  Income       .     .     . 


Six  Months  Six  Months 

Ended Ended. . . .  Increase 


Decrease 
$ 


«p "P «p «p...... 

■  .  I  -      ==== 


724 


AUDITING 


Expenses 


Six  Months  Six  Months 

Ended Ended. . .  .  Increase      Decrease 


Maintenance  Expenses: 
Repairs  and  Renewals  to  Plant 

and  Equipment $. . 

Repairs  and  Renewals  to  Fur- 
niture and  Fixtures 

Foodstuflfs 

Supplies — General       ... 

Clothes    

Linen  and  Bedding     .     .     . 

Fuel 

Light 

Salaries  and  Wages    .     .     . 
Forage  and  Care  of  Animals 

Telephone 

Printing,    Stationery,    and    Ad 

vertising 

Postage,  Telegrams,  Magazines, 

and   Newspapers 
Professional   Services      .     . 

Miscellaneous 

Expenses  Boarded-Out  Children : 

Board  of  Children  . 

Salaries 

Traveling  Expenses 

Clothes 

Professional  Services  .     . 

Miscellaneous      .... 


$ $ $. 


Total  Maintenance  Expenses    $ $ $ $. 


Non-Maintenance  Expenses : 
Interest  on  Mortgage 
Interest  on  Loans  .     . 

Rent 

Insurance     .... 
Taxes 


.  $ $ $ $ 

Total  Non-Maintenance  Ex- 
penses         $ 

Total   Expenses      .     .     .     .     $ 


$ $. 


$... 


$ $... 


CHURCHES  725 

Six  Months  Six  Months 

Ended Ended Increase  Decrease 

Weekly  Cost $ $ $ $ 


I     Excess  of  Income  over  Expenses    $ $ $ $. 

!      Surplus  brought  forward 


Surplus $ $ $ $ 


Churches 

In  the  majority  of  cases  the  audit  of  church  accounts  is 
unsatisfactory  to  the  auditor.  One  reason  is  that  the  church 
treasurer  frequently  is  not  only  the  custodian  of  all  the 
church  funds,  but  is  tacitly  empowered  to  disburse  the  same 
at  will.  There  is  usually  a  total  lack  of  effective  internal 
supervision.  At  times  large  sums  pass  through  a  treasurer's 
hands  without  any  proper  check  being  kept  upon  his  dealings. 

It  is  the  auditor's  duty  to  check  whatever  he  can,  and 
at  the  same  time  to  urge  upon  his  clients,  judiciously  but 
impressively,  the  necessity  for  ordinary  commercial  caution. 
He  should  see  that  all  receipts  are  deposited  in  bank,  and 
if  a  balance  appears  to  be  on  hand,  that  also  should  be  de- 
posited. This  is  preferable  to  an  actual  count  of  cash,  as  in 
the  latter  case  the  church  official  might  exhibit  his  own  funds 
without  any  intention  of  having  them  reach  the  church's 
bank  account.  A  certificate  from  the  bank  direct  to  the 
auditor  should  be  obtained,  this  certificate  indicating  the 
balance  in  bank  belonging  to  the  church  at  a  stated  time. 

In  some  churches  a  collection  register  is  kept  in  which 
are  entered  the  collections  as  made,  the  aggregate  amount 
subsequently  being  transferred  to  a  cash  book.  The  entries 
in  the  collection  register  should,  if  possible,  be  verified  and 
initialed  by  some  one  other  than  the  church  treasurer.  Spe- 
cial collections  should  be  vouched  for  in  a  similar  manner. 
Where  pews  are  rented,  the  pew-rent  register  should  be 


726 


AUDITING 


compared  with  the  cash  book.  If  special  funds  have  been 
devised  to  the  church,  the  securities  held  for  such  funds 
should  be  examined.  Vouchers  should  be  in  evidence  for 
all  payments ;  these  are  to  be  compared  with  the  minutes  of 
that  board  or  committee  of  the  church  whose  duty  it  is  to 
supervise  its  finances. 

In  at  least  one  denomination  the  sentiment  has  been  ex- 
pressed that  the  accounts  of  a  church  whose  treasurer 
handles  moneys  in  excess  of  a  stated  amount  annually  should 
be  audited  by  a  Certified  Public  Accountant.  When  this 
sentiment  becomes  general  we  shall  see  a  decided  improve- 
ment in  the  manner  of  keeping  church  accounts,  as  well  as 
added  safety  in  the  use  and  care  of  church  funds. 

Clubs 

In  auditing  clubs,  particular  attention  should  be  given  to 
the  collection  of  income,  and  it  will  frequently  be  found  that 
improvements  can  be  made  in  this  feature  of  their  account- 
ing systems.  Since  the  members  are  the  club's  proprietors, 
their  co-operation  can  usually  be  obtained,  if  necessary,  in 
safeguarding  the  club  from  being  defrauded  by  its  em- 
ployees or  others. 

Members  should  be  requested  to  pay  by  cheque  to  the 
order  of  the  club  for  all  dues,  house,  restaurant,  and  other 
charges.  Where  peculations  have  occurred  they  have  usu- 
ally been  from  currency  receipts,  as  the  chance  of  detection 
is  comparatively  small  if  there  is  no  adequate  system  of 
check  on  those  handling  the  currency. 

Consecutively  numbered  receipt  forms,  charge  slips,  and 
bills  should  be  used  wherever  practicable,  as  the  office  copies 
thereof  are  valuable  for  auditing  purposes. 

The  collection  of  dues  can  usually  be  verified  by  exam- 
ination of  the  membership  register.     If  necessary,  the  latter 


CLUBS  727 

can,  in  turn,  be  verified  by  comparing  it  with  the  member- 
ship record  at  the  close  of  the  preceding  audit,  and  exam- 
ining the  minutes  for  names  of  new  members  and  of  those 
resigned,  suspended,  or  expelled. 

Wherever  feasible,  registers  should  be  used  as  a  basis  for 
room  charges.  A  good  additional  check  thereon,  which  is 
valuable  for  auditing  purposes,  is  to  have  the  housekeeper 
make  a  daily  record  in  a  suitably  ruled  bound  book  of  occu- 
pancies and  vacancies  of  rentable  rooms.  Consecutively 
numbered  daily  reports  to  the  office  should  form  the  basis 
of  other  house  charges. 

Members'  signatures  are  usually  required  on  orders  re- 
ceived in  the  restaurant  and  bar.  In  some  clubs  where  it  is 
the  practice  to  return  such  orders  to  the  members  monthly 
upon  payment  of  their  accounts,  duplicate  orders  are  ob- 
tained by  the  use  of  carbon  sheets.  If  these  orders  are 
filed  chronologically,  they  may  be  used  in  connection  with 
the  verification  of  the  deliveries  from  stock  of  wines  and 
liquors.  If  members  can  be  induced  to  use  consecutively 
numbered  ticket  books,  either  to  be  paid  for  in  advance  or 
charged  for  in  total,  the  bookkeeping  will  be  entirely  elimi- 
nated (in  the  first  instance)  or  materially  reduced  (in  the 
second)  from  that  necessary  when  each  order  must  be 
charged  to  the  personal  account  of  some  member. 

There  usually  are,  or  ought  to  be,  in  hotels  and  clubs, 
miscellaneous  receipts  from  the  sale  of  bones,  fat,  and  other 
like  sources.  The  practice,  which  still  exists  in  some  clubs, 
of  allowing  the  chef  to  retain  the  proceeds  from  the  sale  of 
kitchen  refuse,  should  be  discouraged,  as  the  pay-roll  should 
show  the  entire  compensation  of  all  employees.  Under  the 
best  of  conditions  it  is  difficult  to  be  certain  that  all  such 
receipts  have  been  accounted  for,  and  comparisons  should 
be  made  of  the  receipts  during  the  period  audited  with  simi- 
lar previous  periods,  and,  in  instances  where  no  such  receipts 


728 


AUDITING 


are  recorded,  investigation  as  to  the  disposal  of  the  offal  and 
scrap  should  be  made. 

Care  should  be  taken  to  ascertain  that  proper  allowance 
has  been  made  for  depreciation  of  china,  glass,  silverware, 
linen,  and  other  furnishings.  Either  of  two  methods  for 
doing  this  may  be  used :  charge  original  cost  of  furnishings 
to  asset  accounts  and  all  renewals  to  expense  accounts,  or 
reappraise  the  entire  stock  at  least  once  annually.  Many 
clubrooms  are  from  to  time  lavishly  redecorated  and  re- 
furnished, and  it  would  be  well,  instead  of  charging  the 
entire  usually  heavy  costs  of  this  nature  to  one  year's  opera- 
tions, to  distribute  the  expenditures  equally  over  a  period 
of  several  years. 

It  is  important  that  all  expenses  be  properly  apportioned 
among  the  various  activities  of  the  club  so  that  it  may  be 
definitely  known  whether  those  departments  which  are  in 
the  nature  of  business  activities  are  in  fact  yielding  sufficient 
revenue  to  defray  all  the  expenses  (including  a  proportion 
of  the  general  expenses)  properly  chargeable  to  such  activi- 
ties. Otherwise  it  may  be  that  departments  which  are  sup- 
posed to  be  self-supporting,  and  which  may  on  the  face  of 
the  figures  appear  to  be  so,  are,  if  all  expenses  chargeable 
thereto  are  taken  into  consideration,  operating  at  a  loss, 
which  is  being  made  up  out  of  members'  dues. 

PROFESSIONAL 

Architects 

The  accounts  of  architects  are  not  usually  so  voluminous 
as  to  preclude  making  a  detailed  audit.  Owing  to  the  fact 
that  men  who  are  professionally  very  able  do  not  always 
have  a  keen  business  sense,  it  is  important  that  the  auditor 
exert  every  means  to  safeguard  the  financial  affairs  of  his 
client  and  protect  him  from  loss. 


ARCHITECTS 


729 


All  payments  should  be  carefully  scrutinized.  This  is 
particularly  necessary  because  some  of  the  expenditures  will 
be  recoverable  from  clients  and  the  auditor  should  see  to  it 
that  all  such  payments  have  been  duly  charged  to  accounts 
w^ith  the  clients. 

A  very  important  part  of  the  audit  is  the  verification  of 
the  commissions  and  fees  charged  to  clients.  Fees  of  speci- 
fied amount  are  sometimes  agreed  upon,  or  are  charged  in 
the  case  of  preliminary  work  (such  as  sketches,  etc.)  done 
in  cases  where  the  proposed  undertaking  is  abandoned. 
Usually,  however,  the  architect's  compensation  is  based  on 
an  agreed  percentage  on  the  cost  of  the  building  and  its 
equipment  where  the  latter  comes  under  the  architect's  su- 
pervision. This  makes  it  necessary  for  the  architect  to  keep 
a  record  of  contracts  let  and  payments  made  thereon.  The 
auditor  should  refer  to  this  record  as  a  means  of  verifying 
the  charges  to  cHents.  Such  a  record  of  contracts  is,  of 
course,  also  a  necessary  part  of  an  architect's  records  for 
the  purpose  of  having  a  basis  on  which  to  issue  certificates 
of  the  amounts  which  are  to  be  paid  by  the  owners  for 
work  done  by  contractors. 

Another  method  which  is  frequently  used  is  to  consider 
60  per  cent  of  the  commission  as  being  earned  when  the 
contract  is  let,  and  the  balance  of  40  per  cent  when  the  pay- 
ments to  contractors  are  made  by  owners  on  the  architects' 
certificates. 

As  there  is  almost  invariably  considerable  work  unfin- 
ished at  the  end  of  a  fiscal  period,  a  basis  of  valuing  it  must 
be  found.  The  author's  experience  is  that  a  quite  satis- 
factory basis  is  the  amount  of  contracts  let,  a  part  of  the 
agreed  rate  of  commission  being  taken  up  on  the  amount  of 
all  contracts  awarded,  and  the  remaining  part  of  the  com- 
mission on  the  amount  of  payments  made  on  the  contracts. 
There  will  be  some  engagements  on  which  the  work  has 


y^Q  AUDITING 

not  .yet  advanced  to  the  point  of  awarding  construction  con- 
tracts. Valuations  of  such  work  will  be  made  by  the  archi- 
tect himself,  frequently  in  round  sums,  and  the  auditor 
should  see  to  it  that  the  estimated  valuations  are,  if  any- 
thing, ultraconservative.  When  the  work  is  only  in  the 
preliminary  stage  there  is  frequently  a  possibiHty  of  the 
project  being  abandoned  or  indefinitely  postponed,  and  in 
such  cases  the  architect  is  not  always  able  to  secure  re- 
muneration commensurate  with  the  work  actually  done. 

Doctors 

The  absence  of  a  uniform  system  of  bookkeeping  on  the 
part  of  medical  men,  and  their  failure,  in  most  instances, 
to  realize  the  value  or  desirability  of  keeping  accurate  ac- 
counts with  patients,  renders  it  difficult  in  the  space  here 
available  to  offer  definite  useful  hints  as  to  the  method  of 
audit.  Assuming,  however,  that  there  is  a  patients  ledger, 
it  may  be  suggested  that  to  go  behind  the  charges  therein 
is  not  necessary.  In  fact,  in  many  instances  it  would  not 
be  possible  to  do  so,  as  the  charges  may  or  may  not  repre- 
sent a  stated  number  of  visits,  as  frequently  a  lump  sum 
is  charged  for  a  case. 

The  auditor  should  endeavor  to  introduce  some  efficient 
system  of  recording  visits  so  that  the  client  may  have  before 
him  all  the  facts  when  making  his  charges.  It  would  be 
especially  satisfactory  for  purposes  of  subsequent  reference 
if  this  record  gave  in  the  case  of  a  family  the  particular  name 
of  the  patient  visited,  though  the  ledger  account  might  ap- 
pear in  the  name  of  the  family  head. 

All  credits  on  the  patients  ledger  should  be  carefully 
checked  by  the  auditor  in  order  that  all  moneys  credited  to 
patients  may  be  properly  accounted  for.  Any  allowances 
that  have  been  made  should  be  particularly  noted.     Many 


LAWYERS  731 

practitioners  employ  one  or  more  assistants  who  are  author- 
ized to  receive  money.  Where  this  is  so,  the  importance 
of  following  ordinary  commercial  precautions  agiinst  fraud 
is  apparent. 

Occasionally  payments  are  made  on  account  of  patients 
for  medicines,  consultation  fees,  or  other  objects.  It  is  im- 
portant that  the  auditor  determine  that  such  charges  have 
been  charged  up  and  duly  collected.  Where  practitioners 
supply  their  patients  with  medicines  and  drugs  it  is  neces- 
sary that  the  accounts  of  druggists,  etc.,  should  be  carefully 
checked,  and  at  balancing  time  an  allowance  will  have  to 
be  made  for  the  value  of  drugs  in  stock. 

Horses  and  carriages  or  automobiles  that  are  the  prop- 
erty of  the  practitioner  should  be  depreciated  at  the  rate 
of  15  to  30  per  cent  per  annum.  If  these  are  rented  it  is 
equally  important  to  include  cost  of  hire  to  the  date  of 
balancing,  or,  in  case  of  payment  in  advance,  to  carry  a 
proportionate  part  forward  as  a  deferred  asset. 

Lawyers 

The  nature  of  a  lawyer's  work,  together  with  a  general 
tendency  on  the  part  of  professional  men  toward  laxity  along 
bookkeeping  lines,  makes  a  complete,  detailed  audit  a  neces- 
sity if  it  is  to  be  effective. 

A  difficulty  which  frequently  confronts  an  auditor  going 
over  a  lawyer's  books  is  that  they  are  the  stock  forms  sold 
by  law  stationers.  These  are  designed  with  a  view  to  sav- 
ing time  rather  than  for  any  other  purpose. 

An  important  requirement  is  to  make  certain  that  the 
amount  included  in  the  balance  sheet  for  outstanding  charges 
represents  the  actual  sum  included  in  bills  to  clients.  Every 
item  of  costs  charged  a  client  might  profitably  be  compared 
with  a  copy  of  the  bill  rendered  to  make  sure  that  all  amounts 


^^2  AUDITING 

chargeable  have  been  properly  debited.  Care  should  be 
taken  to  note  amounts  that  may  have  been  paid  on  account. 
Retainers  may  not  be  so  considered. 

A  not  uncommon  practice  among  lawyers  is  a  failure  to 
distinguish  between  personal  funds  and  those  of  a  client. 
This  very  condition  emphasizes  the  necessity  and  importance 
of  proper  accounts  being  kept  by  those  attorneys  who  wish 
to  avoid  any  possible  reflection  upon  their  manner  of  deal- 
ing with  moneys  intrusted  to  them  by  clients.  This  separa- 
tion of  money  materially  simplifies  the  keeping  of  accounts. 
Each  large  estate  should  have  its  own  bank  account  and 
separate  books,  entirely  independent  of  the  books  of  the 
firm. 

A  "Clients'  Accounts"  in  the  cash  book  should  show  all 
money  received  in  trust  for  clients,  and  if  there  is  but  one 
bank  account,  it  would  be  advisable  to  recommend  separate 
columns,  so  that  the  ''clients'  "  accounts  may  be  distinct  from 
the  "general"  bank  account. 

It  is  a  common  occurrence  for  a  practitioner  to  make  pay- 
ments on  behalf  of  a  client  who  may  not  have  a  credit  bal- 
ance upon  the  books.  It  is  especially  desirable,  therefore, 
that  provision  be  made  for  charges  to  be  so  entered  that  ref- 
erence to  any  account  will  reflect  its  true  condition  and  lead 
to  its  settlement. 

An  important  advantage  in  keeping  large  estates  quite 
separate  from  the  f -^-^^ral  accounts  is  that  the  cost  of  keep- 
ing them,  and  of  1.  '  g  them  audited,  may  then  frequently 
be  charged,  together  with  other  costs,  against  the  estate. 
It  will  be  possible,  also,  to  submit  these  accounts  to  clients 
or  their  representatives  without  disclosing  any  other  transac- 
tion. If  they  be  so  examined  at  regular  intervals,  it  may 
not  be  necessary  to  have  them'  also  audited  by  the  lawyer's 
auditors.  In  this  way  a  further  saving  of  expense  may  be 
effected. 


CONTRACTORS  y^^ 

MISCELLANEOUS 

Contractors 

The  accounts  of  contracting  companies,  erectors,  build- 
ers, engineers,  and  others  engaged  mostly  in  work  carried 
out  under  contract  may  be  included  under  this  caption. 

In  nearly  every  instance  separate  accounts  are  kept  for 
the  cost  of  each  contract,  or,  if  the  work  under  one  contract 
is  very  large,  for  each  of  several  sections  of  a  contract,  which 
are  later  combined  when  each  part  is  completed.  Obviously, 
the  value  of  such  a  system  of  cost  accounts  to  the  client 
depends  upon  the  efficiency  with  which  it  is  carried  out.  The 
auditor  should  examine  it  carefully  to  ascertain  that  it  is 
based  upon  good  accounting  theory  and  that  the  results 
shown  are  in  harmony  with  those  shown  on  the  general 
books. 

The  system  of  preparing  the  pay-roll  and  of  accounting 
for  materials  purchased  and  handled  through  the  storeroom 
should  be  carefully  investigated  to  ascertain  that  all  reason- 
able safeguards  against  fraud  and  loss  are  provided.  Wages 
should  be  paid  by  office  employees  not  connected  with  the 
preparation  of  the  pay-roll. 

The  value  of  work  done  on  uncompleted  contracts  is 
shown  on  the  balance  sheet  under  the  head  of  "Uncompleted 
Contracts"  or  "Work  in  Progress."  The  auditor  should 
request  a  certified  schedule  of  the  ^pfnenditures  on  each  of 
the  contracts  included  in  this  accc^,  ,^1^^  The  schedule  may 
readily  be  verified  in  cases  where  correct  cost  accounts  have 
been  kept,  but  in  other  instances  the  auditor  may  be  obliged 
to  accept  the  schedule  upon  the  certificate  of  the  engineers, 
superintendents,  or  -other  proper  officials,  after  investigating 
unusual  items  and  satisfying  himself  that  every  effort  has 
been  made  to  prepare  the  schedule  correctly. 

As  a  matter  of  fact,  there  is  almost  always  some  check 


^24  AUDITING 

on  the  amount  of  work  completed.  As  the  work  progresses 
under  the  supervision  of  architects  or  engineers,  certificates 
are  secured  from  them  testifying  to  the  quantity  and  qual- 
ity of  work  done  and  authorizing  partial  payments  on 
account. 

The  auditor  may  not  see  these  certificates  unless  he  asks 
for  them.  Contractors  are  usually  more  optimistic  about 
the  proportion  completed  than  is  the  architect  (unless  the 
two  are  working  together  against  the  owner),  so  that  his 
estimate  as  to  the  part  completed  at  a  given  time  should  be 
verified  in  every  possible  way. 

The  cash  receipts  are  also  a  clue  to  the  amounts  certi- 
fied to.  The  stipulated  payments  are  on  a  basis  of  90  per 
cent  of  the  work  completed,  sometimes  more  and  sometimes 
less.  The  contracts  themselves,  which  must  always  be  open 
to  the  inspection  of  the  auditor,  and  which  should  be  called 
for,  will  indicate  the  percentage  reserved  until  after  com- 
pletion and  acceptance. 

It  is  important  to  note  whether  or  not  any  profit  has 
been  taken  on  uncompleted  contracts.  The  profit  on  each 
contract  to  any  date  can  readily  be  ascertained  in  instances 
where  cost  accounts  have  been  kept,  by  preparing  a  memo- 
randum Profit  and  Loss  account  and  making  the  following 
entries  therein : 

Debit : 

All  Direct  Contract  Costs. 

Depreciation  of  Plant  Used  on  Contract  Work. 

Credit : 

Value  of  Work  Certified  to  Date. 
Value  of  Work  Done,  but  Not  .Yet  Certified. 
Stores  and  Materials  Charged  to  Contract,  but  Still 
Unused. 


CONTRACTORS  735 

The  net  credit  balance  of  such  a  Profit  and  Loss  account  will 
represent  the  estimated  profit  to  date;  a  net  debit  balance 
will  represent  the  loss  to  date. 

If  a  contract  is  nearly  completed,  the  estimated  profit 
upon  completion  may  be  ascertained  by  deducting  from  the 
contract  price  the  combined  cost  of  work  to  date  and  the 
estimated  cost  of  completion. 

The  most  conservative  method  is  to  ignore  entirely 
profits  which  may  have  accrued  on  uncompleted  contracts. 
It  could,  however,  hardly  be  claimed  to  be  improper  to  take 
at  least  some  part  of  the  profit  on  the  work  already  done  on, 
say,  a  large  building  contract  extending  over  several  fiscal 
periods,  provided  the  percentage  of  the  work  completed  has 
been  estimated  on  a  conservative  basis  and  a  liberal  allow- 
ance has  been  made  for  contingencies.  Whenever  such 
profits  are  taken,  it  is  the  auditor's  duty  to  satisfy  himself 
that  they  have  been  conservatively  calculated.  The  accounts 
should  show  clearly  the  amounts  of  estimated  profits,  if  any, 
taken  on  uncompleted  contracts,  and  the  auditor  should 
show  them  separately  in  his  statements  and  also  call  atten- 
tion thereto  in  his  report,  if  deemed  necessary. 

Monthly  statements  should  be  requested  from  subcon- 
tractors, as  they  may  have  large  claims  for  work  in  excess 
of  that  called  for  by  their  contracts,  but  for  which  credits  do 
not  appear  on  the  client's  books.  It  may  even  be  found  that 
the  client  has  billed  this  extra  work  to  the  customer,  and 
that  credit  therefor  is  entered  in  the  contract  account. 

At  times  subcontractors  may  do  extra  work  under  an 
agreement  with  the  general  contractor  providing  for  com- 
pensation only  in  the  event  of  collection  therefor  by  the 
general  contractor  from  the  customer ;  changes  in  specifica- 
tions after  subcontracts  have  been  let  also  furnish  grounds 
for  subcontractors'  claims.  Sufficient  reserve  must  be  made 
to  cover  the  probable  amount  to  be  paid  on  such  claims  prior 


^^5  AUDITING 

to  carrying  the  gross  profit  from  the  contract  account  to 
profit  and  loss. 

Real  Estate 

In  auditing  the  accounts  of  a  client  engaged  in  buying, 
holding,  renting,  and  seUing  real  estate,  the  leases  should  be 
examined,  and,  in  the  case  of  office  or  loft  buildings,  should 
be  compared  with  loft  plans,  and  all  the  rentals  accounted 
for.  Actual  inspection  should  be  made  of  properties,  or 
rentable  portions  thereof,  which  are  recorded  on  the  books 
as  vacant  at  the  time  the  audit  is  begun. 

Prepaid  rents,  or  security  deposited  by  tenants,  should 
be  clearly  shown,  and  changes  in  the  latter  during  the  audit 
period  carefully  investigated.  Balances  due  for  unpaid 
rentals,  power,  alterations,  etc.,  can  be  verified  by  cor- 
respondence. 

All  expenses  should  be  vouched  and  comparisons  of  the 
income  and  expenses  of  each  property  and  of  administration 
should  be  made  with  periods  prior  to  that  under  review. 
Extraordinary  expenditures  for  alterations  should  be  called 
to  the  attention  of  the  proprietors  to  ascertain  if  the  tenants 
should  perhaps  have  been  charged  therewith. 

If  properties  are  managed  by  the  client  as  agent  of  other 
owners,  the  contracts  with  the  latter  should  be  examined 
and  the  collection  of  the  commissions  verified.  Balances 
due  to  or  by  owners  may  be  verified  by  sending  statements 
to  the  latter  and  requesting  confirmation  thereof. 

Care  should  be  taken  to  ascertain  that  proper  allowance 
has  been  made  for  accrued  taxes,  interest  on  mortgages, 
and  ground  rents.  The  mortgage  interest  paid  during  a 
full  year  is  a  good  check  on  the  principal  of  the  mortgages, 
in  addition  to  which  the  amount  of  the  latter,  as  well  as  the 
payments  on  account  thereof  during  the  audit  period,  can 
be  further  verified  by  correspondence  with  the  mortgagees. 


REAL    ESTATE  y-^J 

Prepaid  insurance  premiums  should  be  verified  by  calcu- 
lation. The  charges  to  Land,  Buildings,  and  Equipment 
accounts  should  be  examined  to  ascertain  that  they  are  all 
for  additional  land  and  construction  work  or  improvements. 

Accounts  covering  bonuses  which  may  have  been  paid 
for  leases  purchased,  or  the  cost  of  improvements  on  leased 
ground  which  will  revert  to  the  owners  of  the  latter  at  the 
expiration  of  the  ground  rent  leases,  should  be  reduced  at 
regular  intervals. 

Settlement  records  may  be  used  in  connection  with  the 
verification  of  sales  of  real  estate. 

In  the  case  of  undertakings  involving  the  development 
of  large  tracts  and  the  sale  of  lots  therefrom,  care  should 
be  taken  to  ascertain  (if  any  profits  are  calculated  prior  to 
the  disposal  of  the  entire  tract)  that  the  costs  of  the  lots 
sold  have  been  calculated  on  a  conservative  basis. 

The  following  illustration  of  fraud  discovered  in  the 
accounts  of  a  real  estate  agency  will  be  of  interest:  Rent 
collections  were  entered  in  detail  in  a  cash  receipt  book, 
footings  made  each  day,  and  the  total  deposited  to  the  com- 
pany's bank  account.  Th-e  footings  were  verified  by  the 
treasurer  and  agreed  with  the  amounts  credited  in  the  pass- 
books each  day.  After  this  verification,  the  cashier  entered 
additional  items  covering  amounts  which  he  had  taken,  in 
order  that  the  collector,  who  checked  up  the  receipts,  would 
see  that  all  items  had  been  collected.  These  additional  items 
were  not,  however,  included  in  the  totals.  The  cashier  re- 
tained currency  and  cheques  in  his  drawer,  which  he  juggled 
in  order  to  make  up  the  exact  amount  of  the  items  he  was 
supposed  to  be  depositing. 

The  main  cash  book  or  cash  journal  (the  total  of  the 
day's  entries  being  journalized)  included  all  of  the  items 
entered  in  the  cash  receipt  book,  and  fraudulent  footings 
were  made  to  agree  with  the  bank  accounts. 


73^ 


AUDITING 


All  items  were  eventually  posted  in  the  ledger  to  the 
credit  of  the  various  owners,  and  the  footings  and  balances, 
when  inked  in,  were  as  they  should  have  been  had  there 
been  no  defalcation.  The  postings  were  always  from  two  to 
four  months  in  arrears,  and,  in  order  to  prepare  a  trial  bal- 
ance, postings  and  footings  were  falsified.  Some  months 
later  these  errors  were  corrected  as  stated  above. 

The  deficiency  was  partly  concealed  by  depositing  to  the 
company's  credit  cheques  drawn  to  the  order  of  clients  which 
had  been  properly  charged  to  their  accounts,  but  the  cheques 
were  never  sent  to  the  clients. 

The  above-described  fraud  was  practiced  few  about  seven 
years,  and  a  total  of  some  $26,000  obtained  before  the  omis- 
sion of  an  entry  for  one  item  of  receipt  was  questioned  by 
the  collector  and  this  led  to  the  discovery  of  the  fraud. 

Land  and  Development  Companies 

The  operations  of  a  typical  land  development  company 
embrace  the  purchase  of  a  tract  of  land,  the  platting  of  it 
into  streets  and  lots,  the  grading  and  paving  of  the  streets, 
the  laying  of  sewers  and  water  mains,  the  laying  of  side- 
walks and  curbs,  the  placing  of  telephone  and  light  poles, 
and  the  selling  of  the  improved  lots.  Oftentimes  there  are 
other  features  of  the  plan,  such  as  the  building  of  houses 
for  purchasers,  the  extension  of  railway  or  other  transpor- 
tation facilities  to  reach  the  property,  and  possibly  the  tem- 
porary operation  of  one  or  more  industries. 

There  are  many  fine  points  involved  in  the  proper  dis- 
tinction between  expenses  and. additions  to  property.  Un- 
like a  railroad,  the  entire  cost  and  expenses  up  to  the  time 
the  property  is  ready  to  be  marketed  cannot  be  charged 
against  the  property.  Only  such  part  of  the  expense  as 
really  adds  to  the  value  of  the  property,  such  as  the  grading 
and  paving  of  streets,  the  cost  of  the  water  and  sewer  in- 


LAND    AND    DEVELOPMENT    COMPANIES  739 

stallation,  etc.,  is  a  proper  addition  to  the  capital  account. 
Administrative  expenses  and  any  preliminary  selling  ex- 
penses, such  as  advance  advertising,  publicity  work,  print- 
ing, and  the  preparation  of  maps,  must  be  segregated  and 
shown  on  the  balance  sheet  as  deferred  charges  to  future 
operations  until  such  time  as  revenue  begins  to  come  in. 
The  books  peculiar  to  the  business  are  these : 

Real  estate  lot  ledger 

Construction  ledger 

Improved  real  estate  cost  ledger 

Improved  real  estate  operating  ledger 

In  the  lot  ledger  the  lots  are  carried  at  cost.  Unim- 
proved tracts  should  be  represented  by  an  account  with  the 
tract  until  such  time  as  the  tract  is  divided  into  lots,  then 
the  total  cost  of  the  tract  and  improvements  is  spread  over 
the  number  of  lots,  the  Tract  account  is  credited  with  the 
full  amount,  and  an  account  is  opened  with  each  lot.  The 
basis  of  division  of  cost  is  not  the  number  of  lots  in  the 
tract,  but  the  relative  value  of  each  to  the  whole,  depending 
upon  location,  size,  etc. 

The  construction  ledger  contains  only  the  cost  of  build- 
ings and  the  carrying  charges  thereon,  and  does  not  include 
the  cost  of  land.  Upon  the  completion  of  the  building  the 
cost  of  the  same  and  the  cost  of  the  lot  are  transferred  from 
their  respective  ledgers  to  an  account  in  the  improved  real 
estate  cost  ledger  representing  the  building  and  lot  complete. 

The  details  of  the  operation  of  the  property  are  there- 
after carried  in  the  improved  real  estate  operating  ledger, 
from  which  the  credit  or  debit  balance  is  carried  at  the  end 
of  the  fiscal  period  to  proper  profit  and  loss  accounts. 

Following  are  some  of  the  points  that  should  be  covered 
in  the  audit  of  a  going  concern  engaged  in  the  development 
and  sale  of  land : 


740  AUDITING 

Analyze  the  Property  account  from  the  beginning  of  the 
development,  noting  the  nature  of  the  charges  against  this 
account. 

Ascertain  if  there  is  any  record  of  the  prices  at  which 
the  lots  are  to  be  sold  and  compare  selling  prices  therewith. 
If  no  such  record  exists,  see  that  the  sales  contracts  are 
approved  by  one  of  the  principals  before  being  binding  upon 
the  client. 

Obtain  from  the  client  the  basis  for  the  distribution  of 
expenses  between  properties  in  case  more  than  one  property 
is  being  handled.  Then  see  to  it  that  the  proper  distribu- 
tion is  made  for  every  expense  incurred.  The  distribution 
is  usually  made  on  the  stub  of  the  cheque  or  directly  in  the 
cash  book.  There  is  no  reason  why  the  cheque  stub  cannot 
be  dispensed  with,  and  the  cheques  entered  and  distributed 
directly  in  the  cash  book. 

Compare  a  considerable  number  of  the  cashier's  contract 
cards  with  the  ledger,  testing  the  correctness  of  the  interest 
calculations. 

Compare  contracts  entered  into  during  the  period  under 
review  with  the  ledgers  as  to  terms,  name  and  address  of 
purchaser,  etc. 

Compare  the  payments  to  salesmen  for  commissions, 
with  the  card  record  of  contracts  and  with  the  ledgers,  not- 
ing especially  that  commissions  have  been  charged  back  on 
canceled  contracts. 

Compare  the  sales  of  lots  with  map  (retained  by  the 
auditor),  noting  on  the  map  the  price  obtained  and  investi- 
gating wide  fluctuations. 

Compare  open  items  in  the  ''lot  book"  with  the  lots 
unsold  at  the  end  of  the  period  per  the  map. 

See  contract  terms  regarding  taxes,  interest,  etc. 

Send  out  verifications  of  accounts  to  all  customers,  with 
rubber  stamp  request  to  report  inaccuracies  to  auditor. 


HOTELS  741 

Hotels 

The  auditor  should  analyze  the  Earnings  and  Expense 
accounts,  if  necessary,  and  prepare  statements  of  the  financial 
results  in  each  department,  which  should  be  carefully  gone 
over  with  the  proprietors.  Such  departments  as  show  un- 
satisfactory returns  should  be  especially  investigated  to  the 
extent  of  verifying  the  detail  work  for  a  part  of  the  audit 
period.  Hotels  at  summer  resorts  usually  have  more  de- 
partments than  do  city  hotels.  Frequently  the  operations 
of  the  former  include  drug  stores,  various  amusements  and 
excursions  for  guests,  all  of  which  are  sources  of  additional 
income.  Stock  accounts  of  cigars,  wines,  liquors,  etc., 
should  be  carefully  examined  in  the  event  of  the  results  being 
unsatisfactory  in  departments  where  they  are  handled. 

The  auditor  should  satisfy  himself  that  all  receipts  are 
accounted  for,  that  expense  payments  are  either  covered  by 
vouchers  or  properly  approved  pay-rolls,  and  that  such  as 
have  been  made  on  behalf  of' guests  have  been  charged  to 
their  accounts  and  collected.  The  subsidiary  guests'  and 
purchase  ledgers  should  be  proven  with  the  balances  in  their 
controlling  accounts,  and  all  of  the  entries  in  the  general 
ledger  should  be  thoroughly  checked. 

Some  hotels  make  their  charges  for  rooms  to  the  guests' 
controlling  account  from  the  daily  room  report,  which  is  the 
housekeeper's  record  of  the  rooms  occupied.  The  rate  of 
each  room  is  filled  in  and  the  sheet  totaled.  Where  this 
system  is  used  there  is  a  good  check  on  the  clerk  and  book- 
keeper. 

The  inventories  of  china,  glassware,  etc.,  should  be  care- 
fully examined  to  account  for  all  the  equipment  on  hand  at 
the  previous  examination  and  that  purchased  subsequently, 
and  to  ascertain  whether  the  proceeds  from  the  sale  of  equip- 
ment which  has  been  discarded  have  been  received. 

Careful  attention  should  be  given  to  the  question  of  de- 


y^2.  AUDITING 

preciation  of  furnishings,  such  as  china,  glass,  cutlery,  silver, 
linens,  etc.  These  may  be  reappraised  at  periods  when 
statements  are  prepared  or  depreciated  at  such  times  at 
adequate  rates.  Another  good  method  is  to  credit  regularly 
a  reserve  account  and  charge  against  the  Profit  and  Loss 
account  amounts  sufficient  to  cover  the  estimated  actual  re- 
newals and  depreciation  over  a  period  of  years,  and  then  to 
charge  all  renewals  to  this  reserve  account. 

Restaurants 

The  accounts  of  restaurants  are  somewhat  similar  to 
those  used  in  hotels  and  clubs,  although,  by  reason  of 
restaurants  having  few^er  departments,  the  records  are  not 
so  complex.  It  is  a  difficult  matter  to  safeguard  the  pro- 
prietor against  all  possible  fraud  and  to  discover  if  any  has 
been  perpetrated.  The  auditor  should,  however,  carefully 
investigate  the  manner  of  serving  meals  and  collecting  there- 
for, and  should  ascertain  that  the  Earnings  and  Expense 
accounts  in  the  general  ledger  are  so  classified  that  the 
proprietor  can  form  an  opinion  as  to  the  efficiency  of  the 
management. 

In  some  restaurants  the  waiters  do  not  issue  checks  to 
guests,  the  checks  being  issued  by  a  checker  at  the  kitchen 
door,  who  scrutinizes  the  food  or  drinks  served,  and  who 
also  charges  the  waiter's  account  on  a  columnar  checking 
sheet,  which  is  used  as  a  check  at  the  end  of  the  meal  periods 
against  both  the  waiters  and  the  cashier. 

Advertising  Agencies 

It  is  important  for  the  auditor  of  an  advertising  agency 
to  ascertain  that  the  accounting  system  in  use  embraces  a 
good  internal  check  on  the  actual  advertising  done,  on  the 
credits  to  publishers  therefor,  and  on  the  charges  to  the 


THEATERS  743 

clients  for  the  advertising  and  commissions,  and  that  the 
system  is  actually  being  carried  out  in  practice. 

A  good  system  will  provide  for  the  charges  to  the  clients 
(for  the  advertising  and  commissions),  the  credits  to  the 
publishers  (for  the  value  of  space  occupied  in  their  periodi- 
cals), and  credit  to  the  agency's  commission  account  to  be 
made  in  one  entry  from  the  same  original  data.  If  a 
"Space"  account  is  carried  in  the  agency's  general  ledger 
and  is  used  as  the  medium  through  which  the  charges  to  the 
clients  and  the  credits  to  the  publishers  are  made,  the 
auditor  should  ascertain  that  the  balance  therein  consists 
of  the  aggregate  value  of  specific  advertising  not  yet  charged 
to  the  clients,  but  credited  to  the  publishers,  and  of  specific 
advertising  not  yet  credited  to  the  publishers,  but  charged 
to  the  clients. 

The  -contracts  of  the  agency  with  the  publishers  of 
periodicals  and  with  the  clients  should  be  examined,  and 
the  rates  for  advertising  and  commissions  should  be  com- 
pared with  the  agency's  records  to  ascertain  that  the  credits 
to  the  publishers  for  space  and  the  charges  to  the  clients  for 
advertising  and  commissions  are  being  correctly  made. 

*  Theaters 

The  auditor  of  theatrical  accounts  must  at  once  recog- 
nize the  fact  that  a  cash  system  alone  prevails  and  that  all 
persons  connected  with  the  financial  part  of  the  manage- 
ment necessarily  handle  this  currency.  It  is  a  matter  of 
regret  that  managers  cannot  be  induced  to  make  payments 
by  cheque  more  generally,  but  up  to  the  present  representa- 
tions and  arguments  presenting  the  advantages  of  such  a 
system  have  not  been  favorably  received.  However,  the 
practice  is  increasing  gradually,  and  in  time,  it  is  to  be 
hoped,  may  become  general. 


J744  AUDITING 

While  nearly  all  receipts  are  in  currency,  it  is  not  usual 
for  the  auditor  to  be  expected  to  verify  such  receipts;  this 
is  a  function  for  the  treasurer,  who  is  considered  sufficiently 
responsible  for  a  service  that  demands  integrity,  but  no  great 
technical  knowledge  or  unusual  ability. 

The  methods  followed  in  keeping  theater  accounts  are 
as  follows :  About  half  an  hour  after  the  beginning  of  each 
performance  the  treasurer  of  the  theater  counts  his  unsold 
coupon  tickets,  making  up  a  ''rough"  statement  of  the  cash 
which  should  be  on  hand;  to  this  he  adds  the  proceeds  of 
sales  of  "hard  tickets"  (general  admission  and  exchange), 
and  then  submits  this  statement  to  the  treasurer  of  the 
company.  The  two  treasurers  then  count  the  tickets  con- 
tained in  the  doortenders'  boxes,  which,  except  in  stormy 
weather,  agree  very  closely  with  the  rough  statement.  Fol- 
lowing the  count  the  theater  treasurer  makes  out  a  final 
statement,  which  is  signed  by  both  treasurers. 

A  "settlement  sheet"  is  made  up  at  the  end  of  each  week 
by  the  theater  treasurer,  showing  the  gross  receipts  and  the 
share  of  same  due  to  the  theater.  Any  additional  earnings 
are  added  thereto,  and  after  deducting  the  salaries  and 
petty  expenses,  the  treasurer  pays  the  remainder  in  currency 
to  the  manager.  The  latter  usually  pays  all  advertising, 
bill-posting,  light,  etc.,  about  Tuesday  of  each  week  to  cover 
the  previous  week.  In  some  theaters  the  treasurer  pays  all 
bills  and  settles  with  the  manager  for  the  profit  or  loss 
shown  by  the  weekly  statements  only,  but  this  is  not  a  com- 
mon practice. 

The  treasurer  of  the  theater  also  prepares  a  complete 
weekly  statement  for  the  company  treasurer  and  settles 
therefor.  After  making  these  two  settlements  he  would  have 
on  hand  only  the  receipts  of  the  "advance  ticket"  sales, 
which  latter,  as  elsewhere  considered,  should  be  verified. 

It  is  well  to  remember  that  the  object  of  theater  book- 


THEATERS  745 

keeping  is  to  show  the  result  of  each  week's  business  in  a 
manner  that  will  determine  which  attraction  pays  best.  Such 
items  as  annual  license  fee,  rent,  repairs,  etc.,  should,  there- 
fore, be  apportioned  weekly  on  a  basis  of  a  season  of  thirty 
or  thirty-five  weeks. 

The  procedure  in  an  audit  of  theater  accounts  should  be 
somewhat  as  follows : 

Deduct  the  number  of  coupon  tickets  on  hand  from  the 
total  capacity  of  the  house;  find  how  many  "hard  tickets" 
were  furnished  the  treasurer  at  the  beginning  of  season,  de- 
duct number  on  hand  at  time  of  balancing,  and  the  re- 
mainder should  be  accounted  for  in  cash.  The  total  result 
should  then  agree  with  the  cash  and  vouchers  in  the  hands 
of  the  treasurer. 

It  is  necessary  to  see  that  all  nightly  statements  of  the 
period  under  review  are  signed  by  the  treasurers  of  the 
companies.  A  check  on  the  proper  division  of  receipts  may 
be  had  by  examination  of  the  contracts.  These  will  also 
enable  the  auditor  to  know  that  the  proper  shares  of  extras 
have  been  collected  from  companies.  He  should  also  inquire 
into  the  manner  of  preparing  pay-rolls,  in  connection  with 
which  reference  to  an  attendance  book  will  be  necessary. 
This  book  records  the  names  of  persons  entering  the 
premises  by  the  stage  door  before  a  performance,  and  from 
it  fines  for  absence  or  lateness  are  determined.  Proper 
approval  of  all  pay-rolls  should  be  secured. 

As  both  the  treasurer  and  his  assistant  have  access  to  the 
same  cash,  it  will  readily  be  seen  that  a  difficulty  obtains  in 
dividing  this  responsibihty ;  and  a  similar  difficulty  arises  in 
connection  with  the  weekly  payments  to  the  manager.  After 
making  settlement  with  him,  the  cash  remaining  represents 
the  advance  ticket  sales,  which  needs  to  be  verified  at  the 
time.  However,  managers  seldom  count  a  large  number 
of  tickets,  and  just  here  more  than  one  defalcation  has  been 


746 


AUDITING 


covered  up  or  carried  along  by  using  advance  sales  to 
conceal  shortages. 

Strip  tickets  used  largely  by  ^Vaudeville"  or  "continuous 
performance"  houses  are,  of  course,  easily  counted. 

Theatrical  Companies 

A  treasurer's  cash  book  is  the  basis  of  the  accounts  of  a 
theatrical  company;  it  should  be  balanced  weekly,  at  least. 
From  it  several  accounts  as  here  classified  (known  as  "Pro- 
duction" accounts)  are  built  up.    These  include: 

Preliminary  Expenses.  Incurred  during  rehearsals, 
such  as  salaries  of  manager,  musical  director,  and  orchestra, 
hall  rent,  typewriting  parts,  etc. 

Properties.  Including  almost  everything  used  in  the 
stage  representation  other  than  scenery,  costumes,  or  elec- 
trical apparatus,  such  as  furniture,  draperies,  animals 
(either  papier  mache  or  alive),  flowers,  etc.  Perishable 
articles  should,  of  course,  be  absorbed  in  current  expenses 
and  not  charged  to  properties. 

Costumes.     Covering  clothing,  shoes,  wigs,  etc. 

Electrical  Apparatus.  In  this  item  are  included  calcium 
lights  and  special  devices.  If  the  electrical  equipment  is 
rented  instead  of  being  owned,  the  rental  is  chargeable  to 
current  expenses. 

Scenery.  The  work  of  building  and  painting  is  usually 
done  under  contract.  The  scenery  may  be  built  by  one 
firm  and  painted  by  different  artists.  A  dif^cult  landscape 
would  •  probably  be  done  by  a  high-priced  artist,  but  the 
painting  of  a  simple  interior  would  be  done  by  a  cheaper 
man. 

Vouchers  representing  expenditures  for  the  foregoing 
items  should  be  examined.  In  addition,  an  audit  would  in- 
clude the  verification  of  receipts  by  comparing  them  with 


THEATRICAL    COMPANIES  747 

the  nightly  statements  signed  by  the  house  treasurer;  and 
also  seeing  that  the  fines  imposed  by  the  stage  manager  are 
accounted  for.  The  company's  earnings  statement  is  made 
up  weekly  to  agree  with  the  theater  accounts. 

Owing  to  the  unceitainty  of  the  outcome  of  theatrical 
productions,  definite  rules  for  the  treatment  of  depreciation 
cannot  be  stated.  The  whole  cost  of  an  unsuccessful  pro- 
duction should  be  written  off  forthwith;  on  the  contrary, 
the  copyright  of  a  successful  play  does  not  depreciate 
rapidly  in  value.  In  New  York  the  total  cost  of  production 
is  written  off  against  the  first  year's  business.  This  is 
obviously  the  safest  practice. 


CHAPTER    XXVIII 

THE    LIABILITIES    OF    DIRECTORS 

It  may  be  thought  that  the  duties  and  responsibiHties 
of  an  auditor  are  onerous  enough  without  injecting  into  a 
treatise  of  this  nature  an  intimation  that  a  professional 
auditor  is  charged  with  looking  after  the  directors  of  a  cor- 
poration as  well  as  its  officers  and  clerks. 

Such  is  rarely  the  case,  however,  because  most  of  the 
directors  in  the  United  States  who  direct  and  who  perform 
acts  which  require  review,  are  officers  as  well,  and  the 
auditor  examines  their  transactions  as  such  and  not  in  their 
capacity  as  directors. 

Board  Minutes'  Inspection 

Nevertheless,  the  auditor  may  find  in  reading  the 
minutes  of  the  proceedings  of  the  board  of  directors  or  of 
an  executive  or  other  committee,  that  one  or  more  directors 
have  been  intrusted  with  negotiations  to  purchase  property 
or  with  similar  commissions.  In  such  cases  the  auditor 
should  verify  the  transaction  along  the  usual  lines. 

Directors*  Dealings  with  Company 

Where  a  director  receives  no  compensation,  except  per- 
haps a  small  attendance  fee,  the  warning  as  to  participation 
in  meetings  is  not  so  pertinent,  but  it  frequently  happens 
that  directors  are  interested  in  contracts  and  other  transac- 
tions which  are  authorized  or  arranged  at  meetings  in  which 
they  participate. 

If  the  auditor  discovers  this  state  of  affairs  and  is  con- 
vinced of  the  bona  fides  of  the  transactions,  he  need  not 

748 


THE    LIABILITIES    OF    DIRECTORS  749 

criticize,  but  he  can  point  out  the  divergence  from  the  law, 
state  the  proper  procedure,  and  suggest  that  at  the  next 
meeting  of  stockholders  all  such  questionable  acts  of  the 
directors  be  ratified. 

Under  ordinary  circumstances  a  director  is  held  respon- 
sible for  good  faith  only,  but  if  the  minutes  are  not  full  and 
clear  and  at  some  distant  day  a  dissatisfied  stockholder  or 
creditor  looks  sharply  for  unlawful  and  unauthorized  trans- 
actions, the  director  may  find  himself  involved  in  annoying, 
if  not  expensive,  litigation. 

Compensation  of  Directors 

Directors  usually  receive  an  attendance  fee  ranging 
from  $5  to  $50,  and  so  long  as  there  is  nothing  in  the  by- 
laws to  prevent,  the  auditor  can  accept  as  authority  therefor 
a  resolution  which  has  been  regularly  adopted.  The 
minutes  should  record  the  names  of  all  directors  present  at 
each  meeting,  which  will  serve  as  a  check  on  the  amount 
disbursed  for  this  purpose.  Compensation  in  excess  of  the 
attendance  fee  is  rarely  paid  to  a  director  who  is  not  an 
officer. 

If  any  sum  is  voted  to  one  or  more  directors,  the  auditor 
should  ascertain  whether  the  by-laws  permit  the  payment, 
and  whether  the  action  was  taken  at  a  full  board  meeting 
or  whether  any  were  absent  who  might  have  objected.  If 
any  director  who  is  benefited  votes  for  the  resolution,  or  if 
his  presence  is  necessary  to  make  a  quorum,  the  action  is 
voidable  and  may  be  attacked.  All  such  transactions  should 
be  reported  to  and  ratified  by  the  annual  meeting  of  stock- 
holders. If  no  such  action  has  been  taken  by  the  stock- 
holders, the  auditor  should  mention  the  fact  in  his  report. 

It  has  been  held  by  the  courts  that  officers  are  not  en- 
titled to  compensation  simply  because  they  occupy  office  and 


^co  AUDITING 

perform  the  duties  incident  thereto.  Their  salaries  should 
be  fixed  before  election  as  directors,  if  possible.  If  this  is 
not  feasible,  the  amounts  paid  to  the  directors  in  compensa- 
tion for  their  services  should  be  reported  to  the  annual 
meeting  and  be  formally  approved  by  the  stockholders. 

As  a  practical  matter,  where  the  officers  and  directors 
own  all  or  nearly  all  of  the  stock  and  are  acting  in  good 
faith,  it  is  not  necessary  to  report  salaries  nor  other  matters 
of  detail  to  the  stockholders'  meeting. 

Directors  May  Inspect  Books 

It  is  not  generally  known  that  a  director  has  an  abso- 
lute right  to  inspect  the  books  and  papers  of  a  corporation 
of  which  he  is  a  director.  There  are  a  great  many  men 
who  represent  minority  interests  on  a  board  and  who  are 
almost  totally  ignored  in  the  management  of  the  company. 
Information  with  respect  to  finances  or  earnings  is  rarely 
furnished  to  them,  and  is  then  handed  out  as  if  there  were 
no  obligation  to  do  so. 

Auditors  are  frequently  consulted  by  directors  who  state 
that  they  have  tried  to  secure  information  without  success. 
The  auditor  should  advise  them  that  their  legal  right  to 
full  access  to  the  books  is  unquestioned,  and  that  they  may 
be  accompanied  by  a  professional  auditor  if  they  require 
assistance.  Directors  are  charged  with  a  knowledge  of  what 
is  going  on,  and  if  they  fail  to  keep  informed,  they  may  be 
held  jointly  responsible  for  the  acts  of  others.  In  all  cases, 
therefore,  where  they  have  any  doubt  as  to  what  is  going 
on,  it  is  nothing  more  than  simple  business  prudence  to 
employ  an  auditor  who  will  ascertain  exact  conditions. 

The  auditor  should,  as  far  as  possible,  report  to  the 
board  of  directors  individually,  and  it  is  not  improper  for 
him  so  to  word  his  report  as  to  invite  personal  conferences 
with  any  or  all  of  them. 


THE    LIABILITIES    OF    DIRECTORS  751 

A  director  has  a  right  to  inspect  all  of  the  books  and 
papers  of  a  company.  This  includes  the  auditor's  report, 
and  if  an  auditor  has  reason  to  beheve  that  any  director  does 
not  receive  his  report,  he  should  investigate  and  at  least 
ascertain  whether  the  director  is  knowingly  ignorant  or 
whether  he  is  kept  in  ignorance  of  the  existence  of  the 
auditor's  report  because  the  officers  or  his  colleagues  have 
something  to  conceal.  Many  directors  do  not  know  that 
under  certain  conditions  they  are  personally  liable  for  all 
debts  in  excess  of  a  certain  amount.  The  auditor  should 
post  himself  on  this  and  other  points  so  as  to  be  able  to 
make  helpful  suggestions. 

Legal  Liabilities  of  Directors 

It  is  unquestionably  the  duty  of  a  professional  auditor 
to  warn  the  directors  against  the  payment  of  unearned  divi- 
dends, and  if  it  appears  that  his  suggestion  is  unheeded, 
the  auditor  should  seek  legal  advice  in  order  to  be  sure  that 
his  own  position  is  unassailable.  The  report  and  certificate 
will,  of  course,  set  forth  his  position  fully. 

Successful  business  men  might  look  with  more  favor 
upon  directorships  if  they  were  sure  that  affairs  of  the  cor- 
poration would  have  the  periodical  supervision  of  auditors 
who  seek  to  broaden,  rather  than  to  narrow,  their  responsi- 
bihties. 

The  auditor's  consideration  of  the  possible  legal  lia- 
bilities of  directors  need  not  extend  beyond  matters  con- 
nected with  the  accounts,  but  wherever  accounting  ques- 
tions are  involved,  the  auditor's  familiarity  therewith  should 
be  unquestioned.  In  the  American  Malting  case,  decided 
in  New  York  in  1904,  the  court  discussed  the  relation  and 
duties  of  directors  to  the  accounts.  The  decision  is  of  suffi- 
cient interest  to  v/arrant  its  reproduction  in  full : 


J.2  AUDITING 

Archibald  A.  Hutchinson  and  Victor  McElheny,  Jr., 
on  Behalf  of  Themselves  and  All  Other  Stockholders 
of    the   American    Malting    Co.,    Similarly    Situated, 

Plaintiffs, 
V. 

Alexander  M.  Curtiss  and  The  American  Malting  Co., 

Defendants. 

(Supreme  Court,  New  York  Special  Term,  December,  1904.) 

The  statutes  of  this  State  allow  the  recovery,  from  directors  of  a 
foreign  corporation,  of  dividends  unauthorized  by  the  laws  under 
which  such  corporation  is  organized.  It  is  the  foreign  statute  that 
makes  the  dividends  unauthorized,  but  the  recovery  is  to  be  had  under 
the  New  York  statute. 

No  dividends  can  be  made  except  from  "surplus  or  net  profits." 

Contracts  entered  into  by  a  corporation  for  future  deliveries  of  a 
product  not  yet  made  by  it,  from  raw  material  not  yet  purchased,  can- 
not be  taken  as  assets  in  figuring  said  surplus  or  net  profits.  Divi- 
dends cannot  be  made  on  a  mere  hope  or  expectation  of  profits. 

Where  raw  material  is  bought  by  weight,  and  after  manufacture 
is  increased  in  weight  and  value,  the  corporation  is  entitled  to  treat 
it  as  an  asset  at  its  increased  value. 

A  director  who  is  not  present  when  an  unauthorized  dividend  is 
declared  is  not  liable  under  the  statute,  even  though  he  is  present  at  a 
subsequent  meeting  when  the  minutes  of  the  former  meeting  are 
ratified. 

A  director,  sued  for  unauthorized  dividends,  cannot  be  credited 
with  the  profits  which  subsequently  accrued  under  a  change  of 
management. 

A  director  is  not  liable  for  commissions  paid  on  the  sale  of  bonds 
of  a  corporation  which  had  made  unauthorized  dividends  in  the  ab- 
sence of  proof  of  fraud  and  conspiracy  for  the  defendant's  personal 
benefit;  such  loss  is  included  in  the  loss  caused  by  the  illegal  dividends 
which  defendant  must  pay. 

Action  against  director  for  making  unauthorized  dividends. 
Clarke,  J.: 

The  American  Malting  Company  was  organized  under  the  laws  of 
New  Jersey,  September  28,  1897.  It  began  business  on  October  11, 
1897.  On  October  15,  1897,  it  filed  a  copy  of  its  charter  in  the  office 
of  the  Secretary  of  State  of  New  York  to  enable  it  to  do  business  in 
this  State,  and  received  the  usual  certificate  for  that  purpose.  The 
principal  office  of  the  company  was  situated  in  the  city  of  New  York, 


THE    LIABILITIES    OF    DIRECTORS 


753 


at  No.  80  Broadway,  from  its  organization  until  the  fall  of  1899,  and 
since  then  it  has  been  situated  continuously  at  East  River  and  Sixty- 
third  Street,  New  York  City.  The  company  has  had  no  plant  or 
property  in  New  Jersey.  It  has  kept  no  bank  account  there.  It  had 
merely  a  formal,  statutory  office  in  that  State.  Its  capital  stock  is 
$30,000,000,  divided  into  300,000  shares  of  $100  each,  of  which  144,400 
shares  of  preferred  stock  and  145,000  shares  of  common  stock  have 
been  issued.  The  preferred  stock  is  seven  per  cent  cumulative,  having 
a  preference  as  to  dividends  only.  The  company  is  engaged  in  the 
manufacture  and  sale  of  malt.  Its  stock  was  issued  to  promoters  for 
twenty-one  malting  establishments,  situated  in  various  parts  of  the 
United  States,  on  which  they  had  acquired  options,  and  for  $2,080,000 
cash  working  capital.  No  stock-in-trade  was,  however,  acquired  by 
the  issue  of  stock.  As  soon  as  the  organization  was  effected  the 
company  was  compelled  to  purchase  from  the  vendors  of  the  various 
malting  plants  their  stocks  of  barley  and  malt,  for  which  the  company 
issued  its  obligations,  amounting  to  upward  of  $1,600,000.  A  little  over 
two  months  after  the  company  began  business,  and  on  December  20, 
1897,  the  board  of  directors  declared  a  dividend  of  one  and  three- 
fourths  per  cent  to  preferred  stockholders,  payable  January  15,  1898. 
This  amounted  to  $219,450.  Thereafter  a  dividend  at  the  same  rate 
was  declared  and  made  payable  at  each  of  the  following  dates :  April 
15,  1898,  $219,450;  July  15,  1898,  $219,450;  October  15,  1898,  $219,450; 
January  15,  1899,  $219,450;  April  15,  1899,  $252,700;  July  15,  1899, 
$252,700;  October  15,  1899,  $252,700.  In  all  $1,855,350.  Barely  two 
weeks  after  the  payment  of  the  dividend  of  October  15,  1899,  and  on 
November  2,  1899,  the  minutes  of  the  board  of  directors  disclosed  its 
serious  financial  condition  as  reported  to  said  board,  viz.,  its  outstand- 
ing obligations  amounted  to  $2,800,000  in  notes;  that  the  officers  were 
unable  to  negotiate  further  temporary  loans;  that  the  company  needed 
additional  working  capital  and  that  the  board  authorized  the  sale  of 
$4,000,000  mortgage  bonds  of  the  company.  Said  bonds,  six  per  cent 
fifteen-year  gold  mortgage  bonds,  were  subsequently  disposed  of  at  a 
discount  of  $400,000.  This  is  an  action  brought  by  plaintiffs  as  stock- 
holders on  behalf  of  themselves  and  all  other  stockholders  similarly 
situated  against  the  defendant  Curtiss  as  director  of  the  company  to 
compel  him  to  account  for  and  pay  to  the  company  the  amount  of 
the  dividends  declared  and  paid  as  not  having  been  paid  out  of  the 
profits,  but  out  of  the  capital.  The  board  of  directors  having  upon 
demand  refused  or  neglected  to  bring  suit  in  the  name  of  the  com- 
pany, it  was  joined  as  a  party  defendant.  At  first  the  company  put  in 
a  defense,  but  subsequently,  its  management  having  changed,  it  ob- 
tained leave  to  file  an  amended  answer  admitting  the  allegations  of 
the  complaint  and  joining  in  the  prayer  of  the  plaintiffs  for  the  relief 


7^4  AUDITING 

demanded.  In  a  similar  action  against  another  of  the  directors  the 
complaint  was  dismissed  upon  the  trial.  Upon  appeal  the  Appellate 
Division  reversed  that  judgment.  Hutchinson  v.  Stadler,  85  App.  Div. 
428.  That  case  settled  the  law  for  this  court  to  this  extent;  that  an 
action  could  be  maintained  in  the  courts  of  this  State  against  a  director 
of  a  New  Jersey  corporation  to  recover  the  amount  of  dividends  de- 
clared in  violation  of  the  laws  of  that  State.  Two  opinions  were 
handed  down,  in  which  the  learned  justices  arrived  at  the  conclusion 
that  the  action  could  be  maintained  upon  different  grounds.  With 
each  of  these  opinions  a  justice  concurred.  The  fifth  learned  justice 
concurred  in  the  result.  I  cite  this  division  of  opinion  because  this 
court  is  now  called  upon  to  apply  the  law,  as  laid  down  with  this 
practical  embarrassment,  that  while  it  was  the  unanimous  decision  that 
the  action  could  be  maintained,  yet  the  difference  in  the  grounds  there- 
for means  a  difference  of  hundreds  of  thousands  of  dollars  in  the 
judgment  I  am  about  to  order.  As  I  interpret  it  that  case  holds  this 
court  has  jurisdiction  because  section  twenty-three  of  the  Stock  Cor- 
poration Law  of  this  State  provides:  "The  directors  of  a  stock  cor- 
poration shall  not  make  dividends,  except  from  the  surplus  profits 
arising  from  the  business  of  such  corporation;  nor  divide,  withdraw, 
or  in  any  way  pay  to  the  stockholders,  or  any  of  them,  any  part  of  the 
capital  of  such  corporation,  or  reduce  its  capital  stock,  except  as 
authorized  by  law.  In  case  of  any  violation  of  the  provisions  of  this 
section,  the  directors  under  whose  administration  the  same  may  have 
happened,  except  those  who  may  have  caused  their  dissent  therefrom 
to  be  entered  at  large  upon  the  minutes  of  such  directors  at  the  time, 
or  were  not  present  when  the  same  happened,  shall  jointly  and  severally 
be  liable  to  such  corporation  and  to  the  creditors  thereof  to  the  full 
amount  of  the  capital  of  such  corporation  so  divided,  withdrawn,  pai4 
out,  or  reduced" ;  and  because  section  thirty  of  the  General  Corpora- 
tion Law  of  New  Jersey  provides :  "No  corporation  shall  make  divi- 
dends, except  from  the  surplus  or  net  profits  arising  from  its  business, 
nor  divide,  withdraw,  or  in  any  way  pay  to  the  stockholders,  or  any 
of  them,  any  part  of  its  capital  stock,  or  reduce  its  capital  stock,  except 
according  to  this  act,  and  in  case  of  any  violation  of  the  provisions 
of  this  section  the  directors  under  whose  administration  the  same  may 
happen  shall  be  jointly  and  severally  liable  at  any  time  within  six 
years  after  paying  such  dividends  to  the  corporation  and  to  its  creditors 
in  the  event  of  its  dissolution  or  insolvency  to  the  full  amount  of  the 
dividend  made  or  capital  stock  so  divided,  withdrawn,  paid  out,  or 
reduced,  with  interest  on  the  same  from  the  time  such  liability  accrued ; 
provided  that  any  director  who  may  have  been  absent  when  the  same 
was  done,  or  who  may  have  dissented  from  the  act  or  resolution  by 
which  the  same  was  done,  may  exonerate  himself  from  such  liability 


THE    LIABILITIES    OF    DIRECTORS  755 

by  causing  his  dissent  to  be  entered  at  large  on  the  minutes  of  the 
directors  at  the  time  the  same  was  done,  or  forthwith  after  he  shall, 
have  notice  of  the  same,  and  by  causing  a  true  copy  of  said  dissent 
to  be  published  within  two  weeks  after  the  same  shall  have  been  so 
entered  in  a  newspaper  published  in  the  county  where  the  corporation 
has  its  principal  office";  and  because  section  sixty  of  the  Stock  Cor- 
poration Law  of  this  State  provides:  "Except  as  otherwise  provided 
in  this  chapter  the  officers,  directors,  and  stockholders  of  a  foreign 
stock  corporation  transacting  business  in  this  State,  except  moneyed 
and  railroad  corporations,  shall  be  liable  under  the  provisions  of  this 
chapter,  in  the  same  manner  and  to  the  same  extent  as  the  officers, 
directors,  and  stockholders  of  a  domestic  corporation  for:  I.  The 
making  of  unauthorized  dividends  .  .  .  Such  liabilities  may  be  en- 
forced in  the  courts  of  this  State  in  the  same  manner  as  similar 
liabilities  imposed  by  law  upon  the  officers,  directors,  and  stockholders 
of  domestic  corporations."  That  is,  by  virtue  of  the  statutes,  this 
State  allows  the  recovery  of  dividends  unauthorized  by  the  State  of 
New  Jersey  from  directors  of  a  New  Jersey  corporation  in  the  same 
manner  and  to  the  same  extent  as  the  directors  of  a  domestic  corpora- 
tion. That  is,  it  is  the  New  Jersey  statute  which  makes  the  dividend 
unauthorized,  but  the  recovery  is  to  be  had  according  to  the  New 
York  statute.  What,  then,  is  unauthorized?  "No  corporation  shall 
make  dividends  except  from  the  surplus  or  net  profits  arising  from 
its  business."  Net  profits  are  defined  in  the  Century  Dictionary  as 
"what  remains  as  the  clear  gain  of  any  business  after  deducting  the 
capital  invested  in  the  business,  the  expenses  incurred  in  its  manage- 
ment, and  the  losses  sustained  by  its  operation."  And  the  controlling 
question  of  fact  is,  were  these  dividends  paid  from  "net  profits"? 

The  twenty-one  branches,  located  in  many  places  and  in  different 
States,  which  were  actually  engaged  in  the  business  of  manufacturing 
the  malt  from  the  barley,  sent  in  to  the-  general  office  in  New  York 
daily,  weekly,  and  monthly  statements  in  great  detail  of  their  business. 
From  these  statements  branch  books  were  made,  and  from  these  a 
general  set  of  books  was  prepared.  All  of  the  books  and  papers  from 
the  general  office,  which  were  used  in  the  accounting  department,  were 
produced  in  court,  identified,  and  marked  in  evidence.  The  defendant 
objects  to  the  summaries  made  up  from'  these  books,  and  from  any 
and  all  conclusions  of  fact  to  be  drawn  from  said  books  and  said 
summaries  upon  the  ground  that  concededly  the  contracts  and  the 
contract  books  were  not  produced  and  were  not  considered.  It  was 
in  evidence  that  malt  was  always  oversold,  that  contracts  for  future 
deliveries,  running  over  many  months,  were  entered  into,  and  the  claim 
is  that  such  contracts  were  required  to  be  taken  into  consideration 
when  it  came  to  be  determined  whether  any  particular  dividend  was 


756 


AUDITING 


warranted  or  not.  Such  claim,  in  my  opinion,  is  unfounded.  The  law 
is  that  "No  corporation  shall  make  dividends  except  from  the  surplus 
or  net  profits."  These  contracts  were  to  deliver  at  a  future  time  a 
product  not  yet  made  from  raw  material,  not  yet  purchased,  with  the 
aid  of  labor  not  yet  expended.  The  price  agreed  to  be  paid  at  that 
future  time  had  to  cover  all  the  possible  contingencies  of  the  market 
in  the  meanwhile,  and  might  show  a  profit,  and  ran  the  chance  of 
showing  a  loss.  When  the  sales  actually  took  place  they  were  entered 
in  the  books.  But  to  calculate  months  in  advance  on  the  results  of 
the  future  transactions,  and  on  such  calculations  to  declare  dividends, 
was  to  base  such  dividends  on  paper  profits — hoped  for  profits,  future 
profits — and  not  upon  the  surplus  or  net  profits  required  by  law.  It 
does  not  seem  to  me  that  you  can  "divide,"  that  is,  make  a  dividend  of 
a  hope  based  on  an  expectation  of  a  future  delivery  at  a  favorable 
price  of  what  is  not  yet  in  existence,  under  the  statute.  So  the  objec- 
tion to  the  books  upon  that  ground  is  of  no  weight.  From  the  books 
certain  statements  were  made  up  for  the  aid  of  the  court  upon  different 
theories  and  in  different  ways.  One  set  of  statements  was  testified  to 
be  exactly  what  the  books  showed,  without  the  change  of  a  figure. 
These  exhibits  are  known  as  10  P,  10  Q.  As  to  these  statements  I 
do  not  understand  that  there  is  any  controversy  as  to  the  accuracy  of 
the  figures.  A  second  statement,  known  as  10  R,  10  S,  is  identical 
with  the  foregoing,  with  the  elimination  of  one  entry,  which,  as  a 
matter  of  fact,  was  eliminated  by  the  company  itself  some  months 
after  its  entry.  There  was  entered  on  the  books  on  December  31, 
1898,  an  item  of  $388,063.36  of  the  anticipated  or  estimated  future 
profits  on  contracts  for  future  deliveries  running  over  many  months. 
This  entry,  for  the  reasons  stated  in  regard  to  the  contracts  for  future 
deliveries,  was  unjustifiable.  The  company  subsequently  removed  this 
entry.  The  actual  transactions,  that  is,  the  deliveries  of  the  malt 
called  for  by  the.  contracts  and  the  receipts  in  payment  therefor  being 
reported  from  time  to  time  as  they  occurred,  resulting  in  double  credits, 
the  cancellation  or  reversal  of  the  entry  was  absolutely  required.  On 
the  other  hand,  I  find  against  the  plaintiffs  in  regard  to  their  conten- 
tion as  to  the  increase  account.  Barley  is  bought  by  the  bushel  of 
forty-eight  pounds.  Malt,  the  manufactured  article  made  from  barley 
by  steeping,  is  dealt  in  by  the  bushel  of  thirty-four  pounds.  The 
process  of  manufacture  produces  about  fifteen  per  cent  more  of  malt 
by  the  bushel  than  the  barley  measures  from  which  it  is  produced. 
The  amount  of  this  fifteen  per  cent  excess  is  reported  from  each  of 
the  manufactories  month  by  month  as  increase.  Of  course,  this  in- 
crease has  a  value,  as  it  is  sold  as  malt  at  malt  prices.  For  the  purpose 
of  inventory  the  company  has  ascribed  to  it  the  value  of  the  barley. 
This,  plaintiffs  claim,  is  error,  because  that  amount  has  already  once 


THE    LIABILITIES    OF    DIRECTORS  757 

been  charged  to  malt  account,  and  they  say  this  increase  should  have 
no  value  ascribed  to  it  until  sold  and  delivered,  when  its  proceeds  go 
into  the  books  as  cash.  But  it  certainly  is  an  asset  of  the  company, 
and  as  an  asset  at  inventory  periods,  or  when  it  is  necessary  to  ascer- 
tain the  actual  condition  of  the  company,  it  must  be  valued  in  some 
way.  As  it  has  always  been  the  custom  in  the  malting  business  to 
treat  it  as  treated  by  this  company,  I  am  unwilling  to  disregard  that 
custom.  The  accounts  upon  which  I  based  my  conclusions  treated  it 
as  this  company  did.  I  find  that  at  the  time  of  the  declaration  and 
payment  of  the  third  dividend,  July,  1898,  a  deficit  was  caused  thereby 
of  $142,774.59,  and  from  that  time  to  the  end  of  the  period  under 
consideration  none  of  the  dividends  were  paid  out  of  net  profits,  but 
all  were  paid  out  of  capital.  But  it  appears  that  defendant  Curtiss 
was  not  present  at  the  meeting  on  February  28,  1899,  when  the  divi- 
dend paid  Aiwil  15,  1899,  was  authorized.  Under  the  New  York 
statute — under  which  we  are  proceeding — a  director  who  was  not 
present  when  the  dividend  was  declared  is  not  liable.  The  approval 
of  the  minutes  at  the  following  June  meeting,  at  which  he  was  present, 
was  only  the  authentication  of  the  proof  of  what  had  happened  at  the 
previous  meeting.  He  is,  therefore,  not  to  be  held  liable  for  that 
dividend.  He  is  Hable,  in  my  judgment,  as  follows:  For  dividends 
paid  July  15,  1898,  to  the  extent  of  $142,774.59;  October  15,  1898, 
$219,450;  January  15,  1899,  $219,450;  July  15,  1899,  $252,700;  October 
15,  1899,  $252,700— $1,087,074.59,  with  interest  thereon  from  the  several 
dates  of  payment.  As  the  highest  court  of  New  Jersey,  interpreting 
the  law  of  the  State  under  which  this  company  was  incorporated,  held, 
"for  the  full  protection  of  the  company  the  liability  of  the  directors 
must  be  absolute"  (Appleton  v.  Am.  Malting  Co.),  I  find  against  the 
defendant  upon  his  claim  that  the  accrued  profits  of  the  company, 
made  under  a  changed  management,  can  be  credited  in  his  favor  against 
his  liability.  It  is  claimed  that  this  is  a  harsh  law.  If  it  were,  such 
complaint  should  be  made  to  the  Legislature,  and  not  to  the  court. 
It  does  not  seem  to  me  that  in  these  days  of  great  corporations  and 
of  combinations  into  one  of  many  corporations  it  is  asking  too  much 
of  directors,  fiduciary  officers  as  they  are,  that  they  should  obey  the 
law  of  their  incorporation,  and  not  bring  their  companies  to  the  verge 
of  bankruptcy  and  ruin-  by  the  payment  of  quarterly  dividends  on  pre- 
ferred stock  out  of  capital  instead  of  net  earnings.  As  to  the  second 
cause  of  action:  While  the  allegations  are  profuse  as  to  a  "willful, 
fraudulent,  and  illegal  conspiracy,"  the  proof  failed  to  establish  that 
there  was  any  such  conspiracy  for  defendant's  personal  benefit.  The 
cases  establishing  the  cause  of  action  pointed  at  in  these  allegations 
have  been  where  directors  have  diverted  to  themselves  for  their  own 
benefit  the  property  of  the  company.    The  damage  here  flowed  out  of 


758 


AUDITING 


the  making  of  the  dividends,  if  any  there  was.  It  was  alleged  that 
the  company  had  to  issue  bonds,  and  that  the  commissions,  discounts, 
and  interest  thereon  amount  to  $650,000,  which,  as  a  waste  of  its 
funds,  the  plaintiff  seeks  to  recover.  But  as  I  find  that  this  flowed 
as  a  damage  only  from  the  declaration  and  payment  of  the  dividends, 
I  am  persuaded  by  the  language  of  Mr.  Justice  Hatch  in  Hutchinson 
V.  Stadler,  supra,  that  it  does  not  under  the  facts  of  this  case  constitute 
a  separate  cause  of  action.  He  says :  "In  point  of  fact  the  statute  of 
the  State  of  New  Jersey  upon  this  subject,  as  well  as  our  own,  does 
little  more  than  lay  down  a  rule  of  damage  to  be  enforced  against 
directors  for  breach  of  duty.  At  common  law  a  recovery  could  be 
had  for  the  waste,  but  the  extent  of  the  recovery  would  depend  upon 
the  damage  sustained  by  the  corporation  and  be  the  subject  of  proof. 
The  statute  measures  the  loss  sustained,  which  is  usually  the  correct 
arnount,  and  authorizes  a  recovery  therefrom  of  the  individuals  who 
produced  that  result."  It  seems  to  me  that  any  other  theory  would 
result  in  turning  the  amount  recovered  for  illegal  dividends  into  a 
penalty.  The  Court  of  Errors  and  Appeals  of  New  Jersey,  in  this 
very  matter,  as  well  as  our  Appellate  Division,  have  held :  "The 
liability  imposed  by  the  statute  is  not  penal  in  its  character.  Its  sole 
purpose  is  not  to  punish,  but  to  provide  for  the  making  of  compensa- 
tion by  wrongdoers  for  the  injury  sustained  by  their  wrongful  act." 
This  alleged  loss  must,  therefore,  be  held  to  have  been  included  in  that 
for  which  the  defendant  is  required  to  make  compensation  by  paying 
into  the  company  an  amount  equal  to  the  illegal  dividends. 


APPENDIX 

FEDERAL    INCOME    TAX* 

Historical  and  Introductory 

In  all  probability  the  tax  on  income  will  be  a  permanent  source  of 
revenue  in  the  United  States,  and  will  be  assessed  and  collected  not 
only  by  the  federal  authorities,  but  by  the  state  authorities  as  well,  and 
possibly  by  municipalities. 

The  professional  auditor  is  looked  to  as  an  authority  on  this  subject, 
and  a  close  familiarity  with  the  procedure  required  in  making  the 
statutory  returns  will  add  to  his  prestige  and  increase  his  personal 
income. 

Professor  Edwin  R.  A.  Seligman  in  his  book  "The  Income  Tax" 
states  that  everywhere  there  seems  to  be  a  trend  towards  the  income 
tax.  The  history  of  income  tax  development  and  legislation  is  interest- 
ing and  those  who  desire  to  familiarize  themselves  with  the  subject  in 
all  of  its  aspects  should  consult  Professor  Seligman's  book. 

Income  taxation  has  been  known  in  Great  Britain  since  the  close 
of  the  eighteenth  century,  and  has  been  in  continuous  operation  there 
since  1842.  In  many  other  countries  the  principle  has  been  applied  with 
at  least  fairly  satisfactory  results;  but  in  the  United  States  there  has 
been  a  deep-rooted  antipathy  to  the  idea  of  taxing  incomes  until  re- 
cently. During  the  last  few  years  there  has  been  a  gradual,  but  dis- 
tinctly favorable,  trend  towards  this  form  of  taxation.  Probably  this 
change  of  view  has  arisen  out  of  a  rather  natural  selection  of  a  choice 
of  evils,  i.e.,  the  growth  of  public  expenditure  with  its  consequent  bur- 
den upon  taxpayers  has  led  to  a  more  careful  consideration  of  the 
equities  involved  in  the  different  methods  of  raising  revenue.  Indirect 
taxation  has  little  to  recommend  it  to  a  thinking  people,  and  income 
derived  under  a  high  protective  tariff  or  from  the  liquor  and  other 
industries,  must  be  in  the  long  run  temporary  and  unsatisfactory.  Taxes 


♦The  limits  of  this  book  prevent  extended  treatment  of  the  entire  law  In 
all  its  technicalities  and  ramifications,  but  an  attempt  is  made  to  discuss 
all  points  which  arise  in  the  compilation  of  the  returns  of  investors  and 
business  concerns.  _        ^   . ,  ..  ^      .^  ,^ 

The  author  has  freely  consulted  the  "Income  Tax  Guide"  by  Walter  A. 
Staub,  C.P.A.,  and  the  "Income  Tax  Service"  of  the  Corporation  Trust 
Company,  New  York  City,  and  hereby  expresses  his  appreciation  of  the 
authoritative  material  contained  therein.  ^  ^ 

Information  as  to  details  which  cannot  be  touched  upon  here,  Treasury 
decisions  as  rendered,  and  copies  of  rulings  upon  specific  cases,  can  be  secured 
through  services  such  as  that  rendered  by  the  Corporation  Trust  Company. 

759 


760 


AUDITING 


levied  upon  property,  including  money  at  interest,  bonds,  and  other 
forms  of  indebtedness,  inevitably  ignore,  to  a  great  extent,  its  income 
productiveness  and  may  (and  frequently  do)  absorb  the  entire  income. 
Therefore  the  gradual  decline  of  the  antipathy  to  an  income  tax,  and 
the  more  or  less  favor  in  v^^hich  it  is  now  held,  may  be  ascribed  to  the 
education  of  the  public  along  economic  lines. 

Adam  Smith,  in  "The  Wealth  of  Nations,"  has  given  certain  maxims 
with  regard  to  taxation  which  have  become  almost  axiomatic  in  their 
general  adoption.  Among  various  rules  which  he  lays  down,  are  the 
following,  namely,  that  the  subjects  of  every  state  ought  to  contribute 
towards  the  support  of  the  government  as  nearly  as  possible  in  propor- 
tion to  their  respective  abilities,  that  is,  in  proportion  to  the  income 
which  they  respectively  enjoy  under  the  protection  of  the  state;  that 
every  tax  ought  to  be  levied  at  the  time  and  in  the  manner  in  which 
it  is  most  likely  to  be  convenient  for  the  contributor  to  pay  it;  that 
every  tax  ought  to  be  so  contrived  as  both  to  take  out  and  keep  out 
of  the  pockets  of  the  people  as  little  as  possible  over  and  above  what 
it  brings  into  the  public  treasury  of  the  state. 

It  is  probable,  as  already  intimated,  that  the  merits  of  the^  income 
tax  will  lead  to  its  adoption  by  states  and  municipalities.  In  the  past, 
about  twenty  states  have  levied  taxes  on  incomes,  but  their  administra- 
tion of  the  law  has  been  so  inefficient  that  the  lack  of  success  of  these 
laws  has  led  to  their  repeal  or  non-enforcement.  The  few  exceptions 
include  Wisconsin,  where  a  systematic  and  intelligent  attempt  has  been 
made  to  enact  and  enforce  an  equitable  law.  The  Wisconsin  law  was 
passed  in  1911  and  its  administration  so  far  seems  to  justify  a  belief 
that  it  will  be  a  permanent  part  of  the  revenue-producing  legislation  of 
that  state. 

In  confirmation  of  this  possibility  it  is  of  interest  to  note  that  on 
December  15,  1915,  an  income  tax  for  the  State  of  New  York  was 
recommended  by  three  bodies  representing  practically  all  of  the  industry 
and  trade  of  the  City  of  New  York. 

These  bodies  are  the  Chamber  of  Commerce  of  the  State  of  New 
York,  the  Merchants'  Association  of  New  York  City,  and  the  Mayor's 
Committee  on  Taxation  of  New  York  City. 

Before  making  this  favorable  recommendation,  these  bodies  spent 
many  months  in  the  investigation  of  other  methods  of  raising  additional 
revenues  for  the  State  and  City  of  New  York. 

Inquisitorial  Features 

The  inquisitorial  features  are  the  greatest  source  of  objection  to  a 
federal  income  tax.  On  this  point  the  report  of  the  Wisconsin  Com- 
mission for  1912  says: 


FEDERAL    INCOME    TAX 


761 


No  tax  measured  by  ability  to  pay  can  be  administered  without  ask- 
ing searching  questions.  The  more  thoroughly  these  questions  are 
asked,  the  more  certain  honest  people  can  be  that  the  tax  dodgers  are 
paying  their  fair  share.  If  taxation  is  confined  to  visible  things  alone, 
the  assessor  can  get  along  without  asking  questions;  but  such  pro- 
cedure would  exempt  from  taxation  many  of  the  wealthiest  and  ablest 
members  of  the  community.  When  an  assessor  is  trying  to  ascertain  a 
man's  income  or  the  value  of  his  personal  property,  he  must  ask  either 
the  man  himself  or  the  man's  neighbors.  The  second  method  is  ob- 
noxious. The  open  way  is  to  put  the  taxpayer  himself  on  record. 
This  procedure  is  the  honest  man's  only  protection  against  the  tax 
dodger. 

The  old  personal  property  tax  would  have  been  much  more  in- 
quisitorial than  the  income  tax  if  it  had  been  enforced.  It  failed 
largely  because  questions  were  not  asked ;  and  its  failure  resulted  in 
great  financial  burdens  being  shifted  from  the  shoulders  of  certain 
classes  of  the  community  onto  the  shoulders  of  other  classes  far  less 
able  to  bear  them.  The  income  tax  will  be  a  farce  if  searching  ques- 
tions are  not  asked  and  answers  insisted  upon. 

And  on  the  same  point  the  Special  Commission  on  Revenue  and 
Taxation  of  Nebraska  in  its  report  for  1914  says: 

Another  objection  to  an  income  tax  has  always  been  that  it  requires 
taxpayers  to  reveal  information  hurtful  to  their  business  interests.  This 
objection  is  held  to  be  unfounded.  Nothing  is  revealed  by  the  records 
not  already  known  to  the  credit  agencies  and  to  the  business  world. 
A  man's  taxable  income  and  the  tax  thereon  are  matters  of  public 
record,  but  that  is  all.  Nothing  is  known  of  his  exemptions,  or  his 
untaxable  income,  or  of  his  income  derived  from  business  transacted 
without  the  state,  or  of  his  income  derived  from  stocks  and  bonds 
taxed  directly  to  the  corporations  from  which  received. 

Application  to  States  and  Municipalities 

In  many  respects  an  income  tax  is  more  equitable  than  any  other 
in  its  possible  application  to  states  and  municipalities.  There  is  in 
each  community  a  considerable  class  of  persons  who  enjoy  an  income 
out  of  all  proportion  to  the  taxable  property  owned.  In  a  city  like 
New  York,  there  are  many  persons  with  enormous  incomes  who  pay 
no  taxes  whatever  except  the  federal  income  tax.  It  may  be  said  that 
the  heavy  tax  on  real  estate  reaches  them  through  the  rent  they  pay. 
This,  however,  is  a  trifling  amount  to  most  of  them.  As  a  matter  of 
fact,  a  great  many  rich  people  pay  low  rents  and  a  great  many  com- 
paratively poor  people  pay  high  rents.  The  rich  derive  much  of  their 
income  from  personal  property  which  is  now  taxed  on  its  value. 

From  every  point  of  view  the  income  tax  is  an  improvement  over 
the  personal  property  tax.  With  the  removal  of  this  obnoxious  tax 
and  a  proper  scheme  of  administrative  machinery,  the  income  tax  can 
undoubtedly  be  applied  successfully  to  states  and  municipalities. 


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AUDITING 


Importance  of  Good  Administration 

Of  course,  we  must  not  rush  ahead  blindly  or  else  we  will  find 
ourselves  passing  from  one  bad  tax  to  another.  This  thought  was  well 
expressed  by  the  Nebraska  Commission  in  its  1914  report: 

In  our  opinion  it  would  be  unwise  for  Nebraska  to  undertake  so 
delicate  a  task  as  that  of  administering  an  income  tax  law  without 
going  through  some  such  period  of  preparation  for  it  as  Wisconsin  has 
gone  through.  If  it  is  not  understood  from  the  beginning  that  it  will 
be  fairly  and  fully  administered  by  capable  officials,  an  income  tax 
would  become  as  lamentable  a  failure  as  the  taxation  of  intangible 
property  it  is  intended  to  supersede.  Until  the  state  has  built  up  an 
efficient  central  control  through  a  permanent  commission  and  that  com- 
mission by  its  integrity  and  its  efficiency  has  established  itself  in  the 
confidence  of  the  people,  action  looking  to  an  income  tax  ought  to  be 
deferred. 

It  could  hardly  be  made  clearer  that  a  tax  can  be  successful  only 
if  properly  administered,  and  when  administered,  made  as  little  burden- 
some as  possible  to  the  honest  taxpayers. 

Income  Tax  Legislation  in  the  United  States 

Summarizing  the  history  of  the  income  tax  in  the  United  States 
as  confined  to  federal  legislation,  it  is  found  that  at  the  time  of  the 
War  of  1812  an  income  tax  was  proposed,  but  was  rejected  by  Con- 
gress. During  the  Civil  War,  however,  an  income  tax  was  imposed 
and  continued  in  force  until  1872.  The  Wilson  tariff  bill,  passed  in 
1894,  contained  provision  for  a  tax  of  2  per  cent  on  incomes  in  excess 
of  $4,000,  but  this  was  declared  unconstitutional  by  the  Supreme  Court, 
and  no  serious  effort  was  made  to  secure  the  passage  of  an  income  tax 
between  that  time  and  1909,  when  the  Payne-Aldrich  bill  became  law. 
It  is  true  that  the  provision  therein  contained  (taxing  corporations 
upon  net  income  in  excess  of  $5,000)  was  declared  constitutional  by 
the  Supreme  Court  of  the  United  States  on  the  ground  that  it  was  an 
excise  and  not  an  income  tax  within  the  meaning  of  the  Federal  Con- 
stitution which  by  clause  four  of  Article  1,  section  11,  declares  that 
"No  capitation  or  other  direct  tax  shall  be  laid,  unless  In  proportion 
to  the  census  or  enumeration  hereinbefore  directed  to  be  taken";  but 
to  all  intents  and  purposes  it  was  an  income  tax.  The  law  directed  that 
"net  income"  should  be  ascertained  by  deducting  from  gross  income 
received  certain  costs,  expenses  and  losses  paid,  but  in  the  administra- 
tion of  the  law  its  requirements  as  to  income  received  and  expenses 
paid  were  ignored  and  corporations  generally  paid  a  tax  based  on  net 
income  as  ascertained  by  commercial  practice,  i.e.,  by  deducting  ex- 
penses accrued  (whether  paid  or  not),  from  income  earned  (whether 
received  or  not). 


FEDERAL    INCOME    TAX 


763 


Contrary  to  general  expectations,  the  law  met  with  favor  and  the 
opposition  from  corporations  never  materialized.  This  success  en- 
couraged the  legislators  to  propose  an  amendment  to  the  Federal  Con- 
stitution providing  for  the  necessary  authority  to  Congress  to  levy  a 
tax  on  incomes  without  resorting  to  the  subterfuge  of  calling  it  an 
excise  tax.  The  necessary  number  of  states  having  signified  their  con- 
sent to  the  amendment  to  the  Constitution,  the  present  income  tax  law 
was  enacted  October  3,  1913. 

As  an  indication  of  the  change  in  public  sentiment.  Congressman 
Cordell  Hull,  who  wrote  the  income  tax  law  and  who  had  studied  the 
subject  very  thoroughly  prior  thereto,  said  in  Congress: 

During  recent  years  there  has  been  a  general  agitation  and  demand 
in  almost  every  state  in  the  union  and  almost  every  country  in  the 
world  for  intelligent,  fair,  and  practical  reforms  and  readjustments  of 
their  tax  systems,  to  the  end  that  every  citizen  may  be  required  to 
contribute  to  the  wants  of  the  state  or  government  in  proportion  to 
the  revenue  he  enjoys  under  its  protection.  To  this  end  the  doctrine 
of  equality  of  sacrifice  or  ability  to  pay  is  being  universally  invoked. 

I  shall  not  consume  the  time  of  the  committee  upon  the  results  of 
the  operation  of  this  tax  in  the  various  foreign  countries,  except  to 
say  that  the  masses  everywhere  have  a  deep-seated  conviction  that  it 
is  fair  alike  to  every  citizen  and  is  the  only  effective  method  of  equaliz- 
ing tax  burdens. 

This  tax,  in  addition  to  being  fair,  is  productive  and  responsive  to 
changes  in  rates,  and  is  cheap  of  collection. 

The  proposed  tax  is  the  outgrowth  of  centuries  of  tax  legislation 
throughout  the  world.  Those  who  have  been  the  victims  of  our  in- 
tangible and  invisible  tariff  taxes,  with  all  their  features  of  spoliation 
and  plunder,  without  being  able  to  know  the  extent  thereof,  should  and 
will  welcome  the  proposed  tax ;  the  receivers  of  large  incomes  and  the 
owners  of  great  wealth  should  prepare  to  accept  it  as  a  permanent  tax, 
for,  in  my  judgment,  it  has  come  to  stay. 

In  his  message  to  Congress  December  7,  1915,  President  Wilson,  In 
suggesting  a  lower  exemption  and  a  higher  supertax  as  two  of  the 
sources  from  which  the  federal  government  should  increase  its  revenue, 
said: 

We  should  be  following  an  almost  universal  example  of  modern 
governments  if  we  were  to  draw  the  greater  part  or  even  the  whole 
of  the  revenues  we  need  from  the  income  taxes.  By  somewhat  lower- 
ing the  present  limits  of  exemption  and  the  figure  at  which  the  surtax 
shall  begin  to  be  imposed,  and  by  increasing,  step  by  step  throughout 
the  present  graduation,  the  surtax  itself,  the  income  taxes  as  at  present 
apportioned  would  yield  sums  sufficient  to  balance  the  books  of  the 
Treasury  at  the  end  of  the  fiscal  year  1917  without  anywhere  making 
the  burden  unreasonably  or  oppressively  heavy. 

Defects  of  Present  Income  Tax  Law 

The  income  tax  law  as  it  stands  is  by  no  means  perfect.     Its  many 


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AUDITING 


complexities  and  ambiguities  have  caused  dissatisfaction  on  the  part 
of  taxpayers  and  unnecessary  annoyance  to  its  administrators.  Further- 
more, it  is  felt  that  the  Treasury  Department  has  by  reason  of  some 
of  its  interpretations  imposed  excessive  burdens  and  expense  upon  those 
who  have  had  no  intention  of  evading  its  apparent  provisions.  It  must, 
however,  be  realized  that  an  honest  official  cannot  be  expected  to  decide 
doubtful  points  against  the  government,  particularly  when  any  ag- 
grieved party  may  appeal  to  the  courts  for  relief.  Doubtful  points  will 
always  arise,  but  the  more  glaring  defects  in  the  law  will  no  doubt 
be  cured  by  amendments,  and  the  alleged  inequalities  arising  out  of 
interpretations  of  officials  will  disappear  as  the  courts  render  their 
decisions. 

Proceeding  upon  the  assumption  that  the  income  tax  is  here  to  stay, 
a  discussion  of  the  amendment  of  unsatisfactory  provisions  in  the  pres- 
ent law  is  in  order.  Before  making  suggestions  for  amendments,  how- 
ever, one  should  have  the  most  authoritative  data  on  the  general  prin- 
ciples involved  in  the  taxation  of  incomes.  Perhaps  the  highest  au- 
thority in  this  country  is  found  in  the  proceedings  of  the  National 
Tax  Association. 

Copious  extracts  therefrom  will  be  found  herein,  particularly  as 
bearing  on  the  correct  theory  of  taxation.  The  Committee  on  the 
Federal  Income  Tax  of  the  National  Tax  Association  in  its  report  sub- 
mitted to  the  annual  meeting  in  August,  1915,  said: 

There  seems  to  be  no  demand  throughout  the  country  for  a  repeal 
of  the  law.  There  is,  however,  a  general  dissatisfaction  with  its  com- 
plexity and  strong  objection  to  several  of  its  provisions  which  are  con- 
trary to  the  principles  of  just  taxation,  work  unnecessary  hardship,  and 
result  in  unfair  discrimination  between  various  classes  of  taxpayers. 

While  the  Committee  does  not  question  the  propriety  of  any  rulings 
that  have  been  made,  it  desires  to  call  attention  to  the  fact  that  the 
trouble  is  frequently  to  be  ascribed  to  the  lack  of  clearness  in  the  law 
itself.  The  language  of  the  law  is  in  need  of  great  improvement.  The 
lack  of  system  in  the  arrangement  of  subsections  and  paragraphs,  the 
long  and  involved  sentences,  and  the  frequent  introduction  of  provisos 
make  the  act  most  difficult  to  understand.  Your  Committee  desires  to 
express  its  earnest  hope  that  especial  attention  will  be  paid  to  this  point. 
The  recasting  of  the  language  of  the  law  should  be  undertaken  by  ex- 
perts qualified  to  deal  with  so  intricate  and  complex  a  task.  No  con- 
gressional committee  working  under  pressure  of  other  matters,  and 
with  the  limited  time  at  its  disposal,  can  be  expected  to  draft  and  to 
work  out  satisfactorily  the  minute  details  of  arrangement  of  an  act 
such  as  this.  And  it  would  be  of  little  avail  for  your  Committee  to 
undertake  the  task.  Our  first  and  most  important  general  recommenda- 
tion therefore  is  in  favor  of  a  complete  restatement  and  clarification  of 
the  law. 

The  author  was  a  member  of  the  Committee  and  indorses  this  state- 
ment. 


FEDERAL    INCOME    TAX 


765 


Further  comment  in  the  report  just  referred  to  is  reproduced  as  of 
vital  interest  to  all  who  deem  it  necessary  to  be  well  informed  on  the 
subject. 

General  Considerations 

There  are  at  least  four  general  matters  of  considerable  difficulty 
in  the  elaboration  of  any  income  tax  law.  On  each  of  these  points 
there  is  a  wide  difference  of  practice  in  the  various  countries;  and  on 
some  of  them  there  is  by  no  means  a  complete  unanimity  among  stu- 
dents of  the  subject.  These  four  problems  are:  the  general  doctrine  of 
income,  the  double  taxation  of  income,  the  differentiation  of  the  income 
tax,  and  the  taxation  of  corporate  income. 

1.    General  Doctrine  of  Income 

Although  the  man  in  the  street  uses  the  term  very  glibly,  the  precise 
meaning  of  income  is  still  in  dispute.  There  are  at  least  three  different 
concepts  of  income  recognized  in  important  ways,  with  corresponding 
variations  in  the  provisions  of  the  income  tax  laws.  One  of  the  chief 
difficulties  is  to  determine  the  exact  relation  of  income  to  capital.  Is 
everything  that  comes  in  during  the  year  to  be  considered  income,  or 
are  certain  items  to  be  regarded  as  accretions  to  capital ;  and  Tnce  versa, 
are  certain  losses  to  be  deducted  from  gross  income  or  are  they  to  be 
considered  impairments  of  capital? 

A  satisfactory  treatment  of  this  topic  would  require  much  space; 
and  would  involve  an  investigation  of  such  subjects  as  depreciation, 
obsolescence,  depletion  of  natural  resources,  the  temporary  or  permanent 
character  of  gains  and  losses,  and  the  like.  While  such  a  study  would 
manifestly  be  out  of  place  here,  we  have  had  occasion  in  our  specific 
recommendations  to  call  attention  to  certain  glaring  departures  in  the 
present  law  from  the  more  obvious  and  generally  recognized  distinctions 
between  income  and  capital. 

Another  question  in  the  theory  of  income  is  whether  it  is  to  be 
limited  to  money  or  should  include  what  the  economists  call  use  or 
service  income,  whether  measurable  in  money  or  not. 

The  chief  practical  problem  here  arises  in  connection  with  the 
inclusion  of  the  rental  value  of  a  house  occupied  by  the  owner.  A  has 
invested  $100,000  in  a  house  in  which  he  lives ;  B  has  invested  a  similar 
amount  in  5  per  cent  bonds,  and  lives  in  a  rented  house.  If  the  rental 
value  of  A's  house  is  not  included  in  his  income,  he  pays  nothing;  while 
B  pays  tax  on  $5,000.  Obviously,  in  order  to  put  them  on  a  strict 
equality,  income  should  include  rental  value  or  money's  worth  as  well 
as  actual  money  received  as  income.  The  same  arguments  would  apply 
to  that  part  of  a  farmer's  income  which  consists  of  the  produce  con- 
sumed by  him.  Yet,  if  we  depart  from  the  conception  of  money  income, 
the  question  arises,  where  shall  we  stop?  Shall  we  include  the  rental 
value  of  an  automobile,  of  a  library,  of  a  picture  gallery,  of  a  yacht? 

Although  the  income  tax  laws  of  the  Civil  War  period  pursued  at 
first  a  somewhat  different  policy,  the  present  Act  does  not  include  any 
rental  value,  whether  of  real  estate  or  of  other  things.  In  this  respect, 
it  is  in  harmony  with  some  of  the  foreign  laws. 

Again,  theories  of  income  differ  according  as  they  include  or  exclude 
the  idea  of  regularity  of  return.    If  only  that  income  which  is  regularly 


766 


AUDITING 


received  is  to  be  considered  as  such,  gifts,  inheritances,  and  sporadic 
or  occasional  and  irregular  earnings  must  be  excluded.  As  a  matter 
of  fact,  few  income  tax  laws  include  gifts  and  inheritances  in  income ; 
and  the  federal  law  here  follows  the  practice  of  the  majority  with 
respect  to  individual  incomes,  thus  seeming  to  lean  to  the  conception 
of  regularity  or  annual  recurrency. 

A  further  step  in  the  direction  of  regularity  would  be  to  take  the 
average  income  for  a  term  of  years  instead  of  the  income  for  a  single 
year.  Here,  however,  in  contradistinction  from  many  of  the  European 
laws,  the  present  Act  prefers  the  yearly  income  and  does  not  permit 
of  the  three-year  or  five-year  average. 

2.   Double  Taxation  of  Income 

The  second  general  question  is  that  of  the  double  taxation  of 
income  or,  at  all  events,  that  phase  of  the  problem  which  consists  of 
the  simultaneous  taxation  of  the  same  income  by  different  jurisdictions. 
Practically,  the  question  is  as  to  the  taxation  of  income  earned  in  this 
country  by  persons  living  abroad,  whether  aliens  or  citizens ;  and,  con- 
versely, of  incomes  earned  abroad,  but  received  by  residents  of  this 
country. 

The  general  principles  involved  are  in  theory  simple.  Every  govern- 
ment undoubtedly  has  a  right  to  tax  incomes  earned  within  the  country, 
in  so  far  as  the  income  is  derived  from  property  situated  therein.  A 
strong  argument  may  even  be  advanced  for  a  similar  treatment  of  in- 
comes earned  within  a  country,  even  if  they  are  not  derived  from  prop- 
erty. On  the  other  hand,  it  is  obvious  that  a  foreigner  owes  some  fiscal 
obligations  to  the  country  of  his  residence,  even  though  his  income  is 
received  in  the  country  to  which  he  belongs  or  where  he  has  some  prop- 
erty or  business.  It  is  clear,  however,  that  the  above  principles  are 
mutually  exclusive ;  for  if  every  country  were  to  adopt  both  principles, 
many  an  individual  would  be  taxed  on  his  entire  income  simultaneously 
by  two  or  more  countries,  i.e.,  the  country  where  he  lives,  the  country 
to  which  he  belongs,  and  the  country  or  countries  in  which  he  owns 
property  or  carries  on  a  business. 

There  are  two  ways  out  of  the  difficulty.  One  is  for  each  country 
to  exempt  certain  categories  of  income.  The  trouble  with  this  method 
is  that  the  exemptions  granted  by  different  countries  may  either  over- 
lap or  be  inadequate,  so  that  the  individual  will  be  taxed  either  too  little 
or  too  much.  The  other  solution  consists  of  a  mutual  arrangement 
among  the  various  countries  which  levy  an  income  tax,  with  the  result 
that  each  individual  will  be  taxed  upon  his  entire  income  only  once, 
each  country  taking  a  certain  share  of  the  tax. 

International  comity  has  unfortunately  not  proceeded  very  far  along 
this  line.  Such  arrangements  exist  only  between  Germany  and  Austria 
and  between  Great  Britain  and  some  of  her  colonies,  although  there  are 
similar  arrangements  among  various  European  states  affecting  the  in- 
heritance tax.  The  United  States  has  made  no  effort  to  enter  on  this 
path  and  has  contented  itself  with  very  inadequate  and  lame  provisions. 
According  to  our  law,  the  income  of  all  residents  of  the  United  States 
is  taxable,  irrespective  of  the  fact  whether  that  same  income  is  taxed 
abroad.  Furthermore,  the  law  taxes  all  incomes  received  or  earned 
within  the  United  States,  whether  or  not  the  individual  resides  here. 
It  is  to  be  recalled,  however,  that  one  notable  exception  exists;  the 


FEDERAL    INCOME    TAX 


767 


foreign  holders  of  the  bonds  of  American  corporations  are  not  taxable 
on  the  interest  therefrom. 

The  object  of  this  exception  was  probably  to  favor  the  investment 
of  capital  in  American  enterprises  by  foreigners;  just  as  England  in 
her  recent  war  loans  is  endeavoring  to  secure  a  better  market  in  this 
country  by  exempting  the  holders  of  government  bonds  from  her  income 
tax.  It  is  to  be  observed,  however,  that  according  to  our  practice  for- 
eign stockholders  are  not  exempt,  at  all  events  as  far  as  the  normal 
tax  is  concerned,  since  the  corporation  pays  the  tax  irrespective  of  the 
nationality  of  its  stockholders.  On  the  other  hand,  it  is  to  be  noticed 
that  we  exempt  foreign  bondholders  without  inquiring  whether  or  not 
they  are  taxed  on  this  income  by  the  country  of  their  residence.  Finally 
it  must  be  mentioned  that  American  citizens  residing  abroad  are  ac- 
cording to  our  law  taxable  on  their  entire  income,  irrespective  of 
whether  this  income  is  also  taxable  in  whole  or  in  part  by  the  country 
where  they  live.  Under  our  present  law,  therefore,  we  have  ample 
opportunity  for  the  double  taxation  of  certain  persons  and  for  the  non- 
taxation  of  others.     The  situation  is  clearly  unsatisfactory, 

3.   Differentiation  of  the  Income  Tax 

The  third  subject  of  controversy  is  that  of  the  differentiation  of 
the  income  tax.  We  have  introduced  into  our  law  the  policy  of  gradua- 
tion, that  is,  taxing  different  amounts  of  income  at  different  rates.  But 
we  have  not  adopted  the  plan  of  taxing  different  kinds  of  income  at 
different  rates.  The  distinction  in  question  here  is  the  one  usually 
designated  as  that  between  funded  and  unfunded  incomes,  or  between 
property  and  labor  (or  service)  incomes.  England,  for  instance,  dis- 
tinguishes between  earned  and  unearned  incomes ;  Italy  between  prop- 
erty incomes,  business  incomes,  and  pure  labor  incomes. 

Your  Committee  recognizes  that  it  may  be  claimed  that  funded  or 
unearned  incomes  should  be  taxed  at  a  higher  rate  than  unfunded  or 
earned  incomes ;  but  in  this  country  the  question  is  complicated  by  the 
heavy  taxes  imposed  by  our  state  and  local  governments.  The  question 
of  differentiation  must  therefore  be  considered  not  with  reference 
merely  to  federal  taxation,  but  with  reference  to  our  entire  system  of 
federal,  state,  and  local  taxation.  And  when  so  considered,  it  is  quite 
possible  that  by  the  operation  of  state  and  local  property  taxes,  a  suffi- 
cient discrimination  may  already  be  made  between  funded  and  unfunded 
incomes. 

We  regard  it  as  a  fortunate  circumstance  that  the  existence  of  the 
state  and  local  taxes  may  thus  relieve  the  federal  government  from  the 
necessity  of  differentiating  between  different  kinds  of  income.  Such 
differentiation  greatly  complicates  the  structure  of  any  income  tax,  and 
increases  the  difficulties  of  administration.  If  incomes  are  divided  into 
only  two  classes,  funded  and  unfunded,  an  arbitrary  distinction  usually 
has  to  be  made  between  incomes  derived  by  an  individual  or  partnership 
from  the  conduct  of  a  business  enterprise  and  the  dividends  received 
by  stockholders  and  bondholders  in  a  corporate  enterprise  engaged  in 
the  same  line  of  business.  If,  to  avoid  such  difficulties  in  classifying 
income  as  funded  or  unfunded,  the  law  undertakes  to  recognize  three 
classes  of  incomes— funded,  unfunded,  and  mixed— the  structure  of  the 
law  becomes  extremely  complicated,  and  great  difficulties  in  administra- 
tion are  encountered.  As  long,  therefore,  as  our  commonwealths  con- 
tinue to  derive  their  chief  revenue  from  property  taxes,  it  seems  un- 


768 


AUDITING 


necessary  to  differentiate  the  rates  of  taxation  imposed  by  the  federal 
government  upon  different  kinds  of  income. 

4.    Taxation  of  Corporate  Incomes 

The  last  of  the  general  problems  is  that  of  the  taxation  of  cor- 
porate incomes.  It  is  illustrated  by  a  difficulty  connected  with  the 
limitation  upon  interest  deductions  in  the  present  law.  The  amount  of 
interest  paid  by  a  corporation  on  its  indebtedness  which  may  be  de- 
ducted under  the  third  of  the  enumerated  deductions  is  subject  to  an 
arbitrary  limitation.  This  raises  the  general  problem  involved  in  the 
taxation  of  corporate  incomes.  Here  at  least  two  points  of  view  are 
possible.  On  the  one  hand,  the  object  of  an  income  tax  may  be  declared 
to  be  to  tax  all  incomes  in  the  hands  of  the  ultimate  recipients.  All 
income  is  ultimately  received  by  individuals,  and  if  every  individual  is 
taxed  upon  his  entire  income,  the  result  will  be  that  all  incomes  will  be 
reached.  From  this  point  of  view,  any  attempt  to  levy  a  tax  on  cor- 
porate incomes  would  be  incorrect,  for  it  would  result  either  in  the 
same  income  being  taxed  twice,  once  in  the  hands  of  the  corporation 
and  again  in  the  hand  of  the  ultimate  recipient,  or  it  would  be  neces- 
sary to  introduce  some  elaborate  system  of  partial  exemptions,  which 
would  not  be  likely  to  work  out  satisfactorily. 

Another  possible  point  of  view  is  that  the  income  tax  may  be 
regarded  to  a  certain  extent  also  as  a  business  tax,  in  so  far,  at  all 
events,  as  the  income  is  derived  from  business.  Since  most  corpora- 
tions are  engaged  in  business  they  may  therefore  be  said  to  be  liable 
to  such  a  business  tax.  Those  holding  the  second  view  would  contend 
that  it  is  proper  for  the  corporations  to  pay  a  tax  on  their  entire  income 
even  though  the  security  holders  also  pay  a  tax  on  their  entire  incomes. 
And,  regardless  of  these  two  views,  it  may  be  claimed  that  to  exempt 
corporations  entirely  from  any  such  taxation  would  be  injudicious  from 
the  point  of  view  of  fiscal  results. 

The  practice  of  various  countries  is  not  in  absolute  accord  with 
either  of  these  views.  Most  income  tax  laws  more  or  less  illogically 
accept  a  portion  of  each  as  a  compromise.  No  country  exempts  cor- 
porations entirely.  No  country  taxes  both  the  corporation  and  the 
security  holder  on  the  entire  income.  In  our  law,  also,  we  find  a  com- 
promise. 

Your  Committee  presents  these  opposing  views  without  attempting 
in  this  report  to  decide  their  relative  merits,  leaving  for  future  dis- 
cussion the  solution  of  this  important  problem.  As  this  involves  the 
question  of  the  limitation  upon  interest  deduction,  we  likewise  refrain 
from  present  recommendation  of  change  in  this  respect. 

From  this  survey  it  will  be  seen  how  significant  and  how  difficult 
are  some  of  the  still  unsolved  problems  in  the  theory  and  the  practice 
of  the  income  tax.  Your  Committee  desires  simply  to  call  attention  to 
these  general  problems  in  the  hope  that  they  will  be  carefully  considered 
when  the  time  comes  for  a  comprehensive  reform  of  the  law. 

Administration  of  Income  Tax  Law 

The  vital  element  of  success  in  an  income  tax  is  efficient  administra- 
tion ;  hence  everything  which  interferes  with  such  administratiort.  must 


FEDERAL    INCOME    TAX 


769 


be  avoided.  In  the  following  consideration  of  the  required  returns  and 
regulations  and  decisions  covering  the  procedure  imposed  upon  the  tax- 
payer, particular  attention  will  be  given  to  a  comparison  of  what  must 
now  be  done  with  what  should  be  done  to  insure  more  efficient 
administration. 

In  connection  with  the  apparent  discrepancies  between  the  law  and 
modern  accounting  practice,  the  report  to  the  National  Tax  Association 
says : 

Taxpayers  Keeping  Books  of  Account  in  Accordance  with  Statutory 
Requirements  or  Well  Recognized  Methods  Should  be  Permitted 
to  Make  Their  Returns  Based  Thereon.  • 

The  Act  permits  to  individuals  the  deduction  of  expenses  actually 
paid,  interest  paid  within  the  year,  taxes  paid  within  the  year,  and  losses 
actually  sustained  within  the  year;  to  corporations,  expenses  paid  within 
the  year,  losses  actually  sustained  ivithin  the  year,  all  sums  paid  within 
the  year  for  taxes. 

The  law  should  be  amended  so  as  clearly  to  permit  the  deduction 
of  any  of  the  items  referred  to,  if  the  individual  or  corporation  has  so 
entered  them  on  the  books  as  to  constitute  a  liability  against  the  assets. 
Furthermore,  any  regulations  which  tend  to  impose  vexatious  adjust- 
ments of  books  of  account,  where  the  government  does  not  lose  any 
revenue,  are  unwise  and  unnecessary. 

For  many  years  attempts  have  been  made  on  the  part  of  corporations 
and  partnerships  to  arrive  at  a  final  figure  in  closing  their  books,  which 
can  be  relied  upon  as  the  "net  profit"  of  a  year's  operation.  Where 
this  amount  is  determined  by  sound  business  and  accounting  principles, 
and  where  it  substantially  agrees  with  the  law  and  regulations,  no 
immaterial  adjustments  should  be  required,  because  it  means  cor- 
responding adjustments  in  subsequent  years  with  the  result  that  the 
books  of  account  and  the  returns  never  agree. 

For  instance,  some  corporations  accrue  their  taxes,  others  do  not, 
some  partnership  accounts  (particularly  professional  vocations)  are  kept 
on  a  "cash"  basis ;  others,  including  most  commercial  concerns,  are  kept 
on  an  accrual  basis. 

Therefore,  where  a  certain  system  of  accounts  has  been  used  for  a 
period  of  years,  and  where  it  honestly  reflects  actual  profits  or  losses, 
some  leeway  should  be  left  to  the  department  to  obviate  the  expense  and 
annoyance  of  an  almost  complete  analysis  of  a  year's  transactions. 

The  government  would  not  lose  by  such  procedure.  If  expenses 
actually  accrued  within  a  year,  although  not  paid  until  afterwards,  are 
taken  credit  for  in  the  period  when  incurred,  the  most  the  government 
would  ever  lose  would  be  a  postponement  of  a  year  in  collecting  the  tax, 
the  taxable  amount  being  the  same. 

The  attitude  of  some  inspectors  in  criticizing  rates  of  depreciation 
and  similar  deductions  is  apt  to  work  great  harm  from  an  economic 
point  of  view.  Perhaps  most  business  men  are  optimists  and  state 
results  of  a  year's  operations  on  the  most  favorable  basis  possible. 
Banker^  and  other  credit  grantors  have  worked  very  hard  to  correct 
this  tendency,  as  it  usually  leads  to  business  failure.  Liberal  reserves 
and  provisions  for  depreciation  and  other  recurring  losses,  should  be 
encouraged — not  discouraged. 


yyQ  AUDITING 

Business  men  who  have  been  forced  to  be  conservative  and  not  over- 
state their  profits,  take  advantage  of  what  to  them  appears  to  be  official 
government  sanction  to  low  depreciation  and  other  reserves.  The 
government  cannot  lose  any  revenue  by  sanctioning  sound  accounting 
policies,  but  it  can  and  does  encourage  unsound  business  method  by 
criticizing  conservative  procedure. 

Corporations  keeping  books  according  to  the  rules  laid  down  by  the 
Interstate  Commerce  Commission,  or  the  public  utility  commissions  of 
the  various  states,  should  not  be  required  to  make  returns  in  a  form 
which  requires  great  work  and  expense  in  compiling  the  figures.  They 
should  be  permitted  to  file  sworn  copies  of  their  balance  sheets,  supple- 
mented by  such  explanation  as  the  Treasury  Department  may  find 
necessary  of  the  items  which  enter  into  any  particular  account.  To 
exact  a  supplementary  statement,  as  that  on  the  back  of  the  return 
of  net  income  of  corporations  for  the  present  year,  is  a  useless  exercise 
of  inquisitorial  power.  The  value  of  the  supplementary  statements  is 
no  greater  than  that  which  it  supplements.  Neither  can  be  checked  ex- 
cept by  an  examination  of  the  books,  and  the  penalties  for  false  state- 
ments are  no  greater  because  repeated  in  both. 

Investigation  of  Returns  by  Bureau  of  Internal  Revenue 

The  annual  report  of  the  Secretary  of  the  Treasury  dated  December 
6,  1915,  says  inter  alia: 

Many  inaccurate  returns  are  made,  some  deliberately  and  some 
ignorantly,  and  there  are,  without  doubt,  wholesale  evasions  of  the 
law  throughout  the  country.  The  remedy  for  this  is  to  clarify  and 
strengthen  the  law  where  needed  and  to  provide  a  larger  and  more 
effective  field  force  for  the  investigation  and  checking  up  of  income 
tax  returns  and  for  the  discovery  of  those  who  are  liable  for  the 
tax  and  have  failed  to  make  returns. 

It  is  absolutely  certain,  that  the  government  is  losing,  through  in- 
accurate returns  and  evasions  of  the  law,  a  sum  many  times  greater 
than  the  cost  of  the  necessary  field  force  to  investigate  and  check  the 
returns  and  to  bring  to  account  those  who  are  failing  to  make  returns 
as  required  by  law. 

The  report  then  goes  on  to  state  that  on  the  basis  of  additional 
assessments  arising  out  of  returns  examined,  there  would  be  assessed 
on  returns  not  examined,  additional  taxes  to  an  amount  exceeding 
$25,000,000. 

Quoting  further : 

I  do  not,  of  course,  claim  that  the  deductions  here  made  are  con- 
clusive, but  they  demonstrate  that  the  returns  of  individuals  and  cor- 
porations are  inaccurate  to  such  a  degree  that  very  much  additional 
tax  will  be  collectable  as  soon  as  the  returns  are  investigated  and 
checked  by  competent  men,  and  that  it  is  in  the  interest  of  the  govern- 
ment that  a  sufficiently  large  field  force  shall  be  created  to  do  this 
work  thoroughly  and  promptly.  .  .  . 

Such  investigations  and  accounting  have  the  double  effect  of  edu- 
cating taxpayers  to  the  law  itself  and  showing  them  how  their  accounts 


FEDERAL    INCOME    TAX  771 

should  be  kept  to  enable  them  to  make  accurate  returns  to  the  Com- 
missioner of  Internal  Revenue.  It  also  serves  the  purpose  of  putting 
all  taxpayers  upon  notice  that  the  government  has  a  sufficiently  large 
and  competent  force  in  the  field  to  examine  the  returns. 

Inspections  and  investigations  will  be  welcomed  by  those  who  have 
made  their  returns  in  good  faith,  and  no  sympathy  is  felt  for  those  who 
have  attempted  to  evade  just  taxation. 

It  is,  however,  to  be  borne  in  mind  that  many  of  the  offhand  con- 
clusions reached  by  inspectors,  on  which  are  based  additional  assess- 
ments, are  in  themselves  inaccurate  and  on  appeal  are  overruled.  For 
this  reason  taxpayers  should  familiarize  themselves  with  correct  pro- 
cedure, so  that  if  inspectors,  through  erroneous  conclusions,  criticize 
returns  which  are  properly  prepared,  they  may  be  in  a  position  to 
sustain  the  integrity  thereof. 


OBLIGATIONS  IMPOSED  UPON  INDIVIDUALS  BY 
THE  INCOME  TAX  LAW 

For  convenience  the  obligations  imposed  by  the  income  tax  law 
upon  individuals  and  upon  corporations  will  be  separately  discussed. 

It  will  be  found,  however,  that  many  regulations  relating  to  indi- 
viduals also  affect  corporations.  Therefore,  such  points  as  affect  in- 
dividuals and  corporations  alike  will  be  dealt  with  under  individuals, 
and  under  corporations  will  be  found  comments  applicable  to  corpora- 
tions only.  When  preparing  returns  for  corporations,  therefore,  refer- 
ence should  be  had  to  both  sections.  The  index  should  be  freely 
consulted  when  special  points  are  under  consideration. 

The  obligations  of  the  individual  may  be  summarized  as  follows : 

1.  He  must  submit  an  annual  return  to  the  federal  government  on 

or  before  March  1  of  the  succeeding  year,  provided  his  net 
income  is  $3,000  or  over  for  the  taxable  year,  and  must  pay  the 
tax  levied  on  the  net  income  so  reported. 

2.  He  must  withhold  and  pay  over  to  the  federal  government  the 

income  tax  on  certain  kinds  of  payments  which  he  makes  to 
others  (such  as  rent  exceeding  $3,000  per  annum  paid  to  an 
individual)  and  he  must  make  a  report  to  the  government  of 
the  taxes  so  withheld. 

Computing  Net  Income  of  Individuals 

The  Internal  Revenue  Bureau  states  that  "net  income"  shall 
consist  of  the  total  gains,  profits,  and  income  derived  from  all  sources 
(designated  as  gross  income)  less  deductions  numbered  first  to  sixth, 
inclusive,  specifically  enumerated  in  paragraph  B  of  the  act;  and  fur- 


^^2  AUDITING 

ther  states  that  the  "net  income"  of  an  individual  is  represented  by  the 
amount  opposite  item  3  on  page  1  of  Form  1040  revised.  It  is  there- 
fore essential  that  the  form  should  be  studied  in  all  of  its  aspects  in 
order  to  ascertain  who  shall  and  who  shall  not  make  a  return. 

The  forms  of  returns  now  required  are  not  reproduced  here,  because 
they  are  readily  obtainable,  and  no  doubt  minor  changes  therein  will  be 
made  from  time  to  time.  It  is  believed,  however,  that  the  general 
features  of  the  present  forms  will  be  retained  so  that  the  following  dis- 
cussion will  follow  the  order  of  the  forms. 

It  will  be  noted,  for  instance,  that  an  individual  who  has  an  income 
from  dividends  of,  say,  $16,000  per  annum,  plus  less  than  $3,000  from 
other  sources,  need  make  no  return  at  all,  because  income  from  divi- 
dends is  not  taxable  up  to  $20,000  per  annum.  An  individual  having  a 
total  net  income,  inclusive  of  dividends,  of  less  than  $20,000  per  annum, 
may  have  to  make  a  return  because  of  income  from  other  sources,  but 
need  not  include  the  dividends  at  all  in  the  return. 

In  his  report  of  December  6,  .1915,  the  Commissioner  of  Internal 
Revenue  recommended  that  persons  liable  for  the  normal  tax  only  shall 
be  required  to  include  in  their  returns  all  income  derived  from  divi- 
dends. This  will  not  increase  the  tax,  but  it  leaves  to  the  government 
the  determination  as  to  whether  the  individual  is  liable  for  tax  and 
for  what  amount. 

An  individual  having  a  gross  return  from  a  retail  business  of  $50,000 
and  allowable  deductions  of  $47,500,  need  make  no  return  at  all,  because 
his  net  income  is  less  than  $3,000. 

In  view  of  the  various  decisions  as  to  what  is  and  what  is  not  tax- 
able income,  every  individual  whose  gross  receipts  or  income  from  any 
source  during  a  calendar  year  exceed  $3,000,  should  secure  a  copy  of 
the  form,  study  its  requirements,  and  answer  the  questions.  It  may 
be  that  the  allowable  deductions  will  produce  a  net  income  of  less 
than  $3,000  (in  which  case  the  return  need  not  be  made  under  oath  and 
filed  with  the  collector  of  internal  revenue  for  the  district  in  which  he 
resides,  as  is  required  where  the  net  income  exceeds  $3,000),  but  no 
possible  harm  can  ensue  from  the  preparation  of  the  return.  On  the 
other  hand,  the  compilations  of  data  requisite  to  the  answering  of  the 
questions  should  be  interesting  and  beneficial,  and  if  in  subsequent  years 
one  is  fortunate  enough  to  have  a  gross  income  so  large  that  the  in- 
clusion of  every  allowable  deduction  fails  to  bring  the  net  income  down 
to  $3,000,  then  the  labor  of  familiarizing  oneself  with  the  requirements 
will  not  have  been  in  vain.  It  is  also  to  be  expected  that  at  some  future 
time  a  return  will  be  required  from  each  individual  with  a  gross  income 
of  $3,000  and  over,  although  the  allowable  deductions  may  reduce  his 
net  income  to  the  point  of  exemption.  Such  a  requirement  is  reason- 
able, because  the  present  law  leaves  the  taxpayer  to  be  the  judge  of 


FEDERAL    INCOME    TAX  773 

the  propriety  of  deductions  which  may  reduce  his  net  income  below 
the  minimum.  The  government  should  be  the  judge  of  such  deductions 
— not  the  taxpayer. 

The  Commissioner  of  Internal  Revenue,  in  his  report  of  December 
6,  1915,  recommended  that  the  law  be  amended  to  provide  for  a  return 
of  gross  incomes  of  $3,000  or  over,  and  whether  or  not  the  normal  tax 
liability  has  been  satisfied  by  withholding  at  the  source. 

GROSS  INCOME 

The  items  of  taxable  income  are  subdivided  here  into  convenient 
groups,  following  generally  the  classification  in  the  law.  These  will 
now  be  considered  in  detail. 

Salaries  and  Wages 

Salaries  and  wages  need  not  be  accounted  for  in  the  return  until 
payment  is  made  and  received.  Unquestionably  this  is  the  most  con- 
venient method  of  dealing  with  salaries  and  wages.  Very  few  recipients 
of  salaries  keep  double-entry  books,  and  it  would  require  some  such 
system  or  its  equivalent  to  attempt  to  report  the  salary  earned  within  a 
calendar  year  but  partly  paid  prior  or  subsequent  thereto. 

The  procedure,  however,  is  not  consistent  with  that  required  in  the 
regulation  that  there  must  be  reported  "all  income,  etc.,  arising  or 
accruing  from  all  sources  whatever  in  the  calendar  year  for  which  the 
return  is  made"  (Art.  4,  Reg.  33),  and  reference  to  T.  D.  2224*  indi- 
cates that  the  Treasury  Department  assumes  that  salaries  or  wages 
may  have  been  reported  as  income  before  being  collected  in  cash.  This 
decision  provides  that  uncollected  wages  and  salaries  will  not  be  al- 
lowed as  deductions  from  gross  income  under  the  item  of  bad  debts, 
unless  the  income  which  they  represent  has  been  included  in  a  return 
of  gross  income. 

Of  course,  anyone  keeping  books  on  an  accrual  basis  (that  is, 
entering  all  income  as  earned  and  all  expenses  as  incurred)  and  so 
reporting,  would  hardly  be  criticized  by  the  collector  of  internal  revenue. 
If  any  part  of  the  accrued  income  so  reported  becomes  uncollectable, 
T.  D.  2224  provides  a  means  whereby  credit  can  be  taken  therefor  as  an 
allowable  deduction. 

The  compensation  of  all  officers  and  employees  of  a  state  or  any 
political  subdivision  thereof,  except  when  such  compensation  is  paid 
by  the  United  States  government,  is  specifically  exempted  by  the  law 
and  is  not  taxable. 

This  includes  public  school  teachers,  etc.    When  such  state  officers 


*The  initials  T.  D.  when  used  in  citations  refer  to  official  Treasury  decisions. 


yy^  AUDITING 

or  employees  are  compensated  by  the  United  States,  they  must  include 
such  income  as  taxable. 

Rent  Equivalent 

Where  an  individual  is  furnished  living  quarters  in  addition  to 
salary,  the  rental  value  of  such  living  quarters  is  regarded  as  compen- 
sation subject  to  the  income  tax.  (T.  D.  2090.) 

This  ruling,  in  itself,  is  equitable  but  the  principle  involved  is  not 
followed  in  other  rulings.  For  instance,  many  factory  superintendents 
are  permitted  to  live,  rent  free,  in  houses  belonging  to  their  employers. 
Under  this  ruling  they  are  required  to  ascertain  the  rental  value  thereof 
and  report  it  as  taxable  income.  If  an  individual  holding  a  similar 
position  owns  his  own  house,  he  is  not  required  to  report  the  rental 
value. 

Living  quarters  or  parsonages  furnished  to  clergymen  are  taxable 
upon  a  reasonable  valuation  thereof. 

Compensation  for  Services  as  Trustee 

A  ruling  holds  that  if  no  determination  was  made  of  the  amount 
due  the  trustee  of  an  estate  as  compensation  for  his  services  over  a 
period  of  years  until  the  trust  was  terminated,  the  amount  allowed 
him  should  be  returned  in  full,  subject  to  allowable  deductions,  as 
income  for  the  year  in  which  paid;  and  should  not  be  prorated  over 
the  length  of  time  during  which  he  served  as  trustee. 

This  ruling  could  hardly  be  sustained  if  it  could  be  shown  that  a 
definite,  or  an  approximately  definite,  portion  of  the  fee  had  been  earned 
and  had  accrued  at  March  1,  1913.  The  trustee  could  not  legally  be 
taxed  on  income  which  accrued  prior  to  the  date  the  law  went  into 
effect. 

Heat,  Light,  etc.;  Other  Taxable  Items 

Amounts  received  by,  or  paid  for,  an  officer  for  heat  and  light  shall 
be  returned  as  income.     (T.  D.  2079.) 

This  applies  to  army  officers  who  receive,  in  addition  to  their  sal- 
aries and  allowances  for  rent,  a  further  allowance  for  heat  and  light. 
As  the  amounts  paid  are  readily  ascertainable,  it  may  be  assumed  that 
all  army  officers  whose  aggregate  incomes  exceed  the  exemption  pay 
the  tax  thereon.  There  are  many  other  individuals  who  receive  allow- 
ances of  a  similar  nature  who  should  be  taxed  thereon.  For  instance, 
many  corporation  officials,  particularly  those  who  live  near  industrial 
plants,  receive  or  enjoy  telephone  service,  fuel,  use  of  automobiles,  and 
many  other  perquisites  which  under  the  ruling  cited  are  taxable.  It  is 
usual  for  officers  of  automobile  concerns,  manufacturers,  and  dealers, 


FEDERAL    INCOME    TAX  775 

to  have  the  full  use  of  motor  cars  for  pleasure  and  business  uses. 
Officials  of  railroad  companies  receive  passes  good  over  their  own 
and  other  lines.  These  are  used  for  personal  as  well  as  business  pur- 
poses. An  individual,  for  instance,  may  use  this  pass  to  go  to  and 
from  his  golf  club  or  on  pleasure  trips. 

Should  emoluments  of  this  kind  be  reduced  to  their  equivalent  in 
money,  and  reported  as  taxable  income?  The  point  is  really  an  im- 
portant one,  for  the  income  tax  to  be  successful  must  be  administered 
impartially  and  equitably.  If  army  officers^  who  are  not  overpaid,  are 
required  to  pay  the  tax  on  the  money  equivalent  of  rent,  light,  and 
heat,  then  other  individuals,  most  of  whom  are  better  able  to  pay,  must 
pay  on  similar  income.  "Compensation  for  personal  service  of  what- 
ever kind  and  in  whatever  form  paid"  is  hardly  subject  to  doubt  as  to 
its  meaning.  The  only  difficulty  which  should  arise  will  be  the  dis- 
tinction between  compensation  which  takes  the  form  of  reduced  living 
expenses  (taxable  because  not  allowable  as  deductions),  and  the  receipt 
of  similar  privileges  which  do  not  tend  to  reduce  the  living  expenses 
of  the  recipient.  For  instance,  automobiles  are  frequently  furnished  to 
salesmen  for  exclusive  business  use.  Here,  of  course,  no  return  would 
be  made.  If  the  salesman  is  permitted  to  use  the  car  for  personal  or 
family  use,  then  it  might  be  thought  that  he  should  ascertain  the  rental 
value  for  the  time  so  used  and  include  such  amount  as  taxable  income. 
In  such  a  case,  however,  there  would  be  no  obligation  to  make  the 
calculation.  It  is  a  fair  assumption  that  if  the  car  were  not  furnished 
free  of  charge,  no  similar  expense  would  be  incurred,  and  if  the  item 
is  not  the  equivalent  of  a  reduction  of  "personal,  living,  or  family 
expenses,"  it  is  not  taxable. 

If,  however,  an  officer  of  an  automobile  concern  has  the  exclusive 
use  of  a  car,  and  does  use  it  for  other  than  business  purposes,  and  if 
it  is  a  fair  assumption  that  he  would  own  and  operate  a  car  even  if  he 
had  to  pay  for  it,  then  he  should  ascertain  the  total  cost  of  operation 
for  a  year  and  prorate  such  cost  equitably,  reporting  as  taxable  income 
the  estimated  saving  of  expense  arising  out  of  its  use  and  of  which  he 
enjoyed  the  benefit  as  additional  compensation. 

Of  course,  he  would  report  on  the  basis  of  actual  cost,  taking  the 
benefit  of  manufacturers'  or  wholesale  prices,  rather  than  what  he  might 
have  paid  if  he  had  not  been  in  a  position  to  secure  such  concessions. 

The  Treasury  regulations  specifically  state  that  "board,  lodging  or 
other  consideration  received  in  lieu  of  rental  is  income  equal  in  amount 
to  the  indebtedness  in  payment  of  which  it  is  received,  and  should  be 
included  in  any  return  of  annual  net  income  its  recipient  is  required 
to  render  under  the  provisions  of  the  income  tax  law." 

The  answer  to  these  questions  and  the  basis  upon  which  the  treat- 
ment of  free  rent  and  other  items  should  be  decided,  probably  depends 


77^ 


AUDITING 


upon  the  contractual  relation  between  the  one  who  pays  and  the 
recipient.  If  the  rent,  fuel,  automobile,  and  similar  privileges  are 
part  of  the  employment  contracts,  express  or  implied,  and  thus  show 
on  their  face  that  more  or  less  value  attaches  thereto,  then  the  cash 
equivalent  of  the  items  is  taxable. 

If,  however,  the  privileges  are  not  part  of  a  contract,  and  are  pure 
gifts  and  no  diminution  of  compensation  results  therefrom,  then  they 
do  not  constitute  taxable  income. 

Professions  and  Vocations 

Where  services  rendered  are  of  such  nature  as  to  be  compensated 
by  fee,  it  would  seem  that  where  the  service  is  completed  and  the  fee 
is  due  within  one  year,  but  not  collected  until  the  following  year,  that 
such  fees  should  be  reported  as  accrued  income.  If  the  fee  becomes 
uncollectable,  it  may  be  deducted  in  a  subsequent  return. 

The  Treasury  decision  on  this  point  seems  to  hold  that  professional 
fees  need  not  be  reported  until  collected,  although  it  is  somewhat  am- 
biguous.   It  is  as  follows  : 

Where  a  service  and  payment  period  is  divided  by  the  end  of  a 
taxable  year,  the  compensation  for  the  period  so  divided  at  the  end 
of  the  year  will  be  accounted  for  in  the  return  for  the  year  in  which 
payment  is  made  and  received.  Where  the  service  is  of  such  nature 
as  to  be  compensated  by  fee,  or  of  such  nature  that  no  portion  of  the 
amount  becomes  due  until  the  service  is  completed,  then  the  total 
amount  of  the  compensation  should  be  included  in  the  return  for  the 
year  in  which  the  compensation  is  received.     (T.  D.  2090.) 

It  may  be  assumed  that  this  decision  permits  the  postponement  of 
the  reporting  of  all  professional  fees  until  they  are  collected,  although 
it  operates  to  tax  cash  receipts  instead  of  true  income. 

Where  the  taxpayer  prefers  to  prepare  his  return  from  his  cheque 
book  or  cash  book,  no  fault  will  be  found  therewith.  In  such  cases 
it  is  suggested  that  if  the  taxpayer's  income  arises  from  fees,  etc.,  a 
cash  book  with  several  columns  will  be  most  useful.  On  the  receipt 
side  all  items  of  receipts  from  fees,  etc.,  should  be  entered  in  a  column 
reserved  for  the  particular  purpose,  so  that  at  the  end  of  the  year  the 
aggregate  of  such  column  will  be  the  proper  amount  to  include  in  the 
return.  If  the  tax  has  been  withheld  by  any  other  person  on  any 
amount  included  herein,  the  aggregate  for  the  year  should,  of  course, 
be  separated  to  accord  therewith. 

Easter  offerings,  and  fees  received  by  clergymen  for  funerals,  masses, 
marriages,  baptisms,  etc.,  are  considered  income  subject  to  tax.  Christ- 
mas gifts,  however,  are  not  considered  income  within  the  meaning  of 
the  law  and  should  not  be  included  in  a  return. 


FEDERAL    INCOME    TAX  yyy 

Business,  Trade,  Commerce;  Sales  or  Dealings  in  Property, 
Whether  Real  or  Personal 

Under  this  head  the  individual  must  report  the  gross  income  from 
his  business  if  conducted  by  him  as  a  sole  proprietor.  If  he  is  a  mem- 
ber of  a  firm,  his  share  of  the  net  profits  is  to  be  reported  elsewhere 
(see  page  783). 

If  books  of  account  are  kept  according  to  the  double-entry  system, 
it  should  be  possible  to  compile  therefrom,  without  difficulty,  the  in- 
formation required.  By  reporting  under  this  head  the  gross  profits, 
under  the  first  item  of  allowable  deductions  the  administrative  and  sell- 
ing expenses  (page  789),  and  under  subsequent  items  of  deductions 
interest,  taxes,  losses,  bad  debts,  and  depreciation,  there  should  be  ex- 
hausted all  items  shown  by  the  books,  except  personal  withdrawals  and 
capital  investments. 

If  rents,  interest,  royalties,  etc.,  are  included  in  business  income,  care 
must  be  taken  to  exclude  such  items  under  other  heads. 

If  an  individual  has  a  fiscal  year  for  business  other  than  December 
31,  he  must  nevertheless  report  as  of  December  31,  and  do  the  best  he 
can  to  reconcile  the  results  shown  by  his  books  for  the  fiscal  year  with 
the  figures  required  for  a  calendar  year  basis.  The  adjustments  are 
not  easily  made,  and  are  both  annoying  and  expensive  in  time  and  labor. 

Furthermore,  as  no  real  benefit  accrues  therefrom  to  the  government, 
it  is  hoped  that  the  law  will  be  amended  to  permit  an  individual  to 
report  for  his  fiscal  year,  as  can  now  be  done  by  a  corporation  and  a 
partnership.  If  such  an  amendment  is  not  feasible,  then  the  Treasury 
Department  should  be  requested  to  provide,  by  suitable  regulations 
which  are  now  in  its  power,  for  the  inclusion,  by  an  individual  in  his 
returns  as  of  December  31  for  a  return  of  transactions  to  the  end  of 
his  fiscal  year  next  preceding  December  31.  He  would,  of  course, 
include  the  transactions  of  a  full  twelve  months. 

If  a  member  of  a  partnership,  he  can  include  the  figures  as  shown  by 
the  partnership  books  when  closed  at  the  end  of  the  fiscal  year,  and  need 
not  attempt  to  make  a  special  closing  at  December  31  for  the  purpose 
of  the  return.     (See  page  783,  et  seq.) 

This  convenient  method  of  reporting  applies  only  to  certain  classes 
of  taxpayers,  however.  For  some  mysterious  reason  those  who  deal 
in  other  things  than  ordinary  merchandise  are  discriminated  against 
and  instead  of  being  permitted  to  calculate  their  losses  or  gains  upon 
the  usual  and  reasonable  methods,  the  government  has  decreed  that 
those  who  deal  in  real  estate,  securities,  etc.,  must  be  penalized  for 
so  doing  to  the  extent  that  an  accurate  book  record  must  be  kept  of 
each  item  (even  if  these  run  up  into  the  tens  of  thousands),  its  cost 
and  the  date,  and  its  sale  and  the  date  (even  though  many  years  sub- 


778 


AUDITING 


sequently),  and  that  the  modern  and  sensible  system  of  inventories 
must  be  dispensed  with  and  a  very  annoying,  expensive,  and  unreason- 
able system  substituted  therefor.  Of  course,  most  taxpayers  have  been 
unable  to  comply  with  this  regulation,  and  in  time  it  will  have  to  be 
modified. 

On  this  point  the  report  of  the  National  Tax  Association  says : 

Taxpayers  Should  be  Permitted,  with  the  Approval  of  the  Com- 
missioner OF  Internal  Revenue,  to  Adopt  the  Practice  of  Deter- 
mining AND  Reporting  Gains  or  Losses  by  Annual  Inventory  of 

Values. 

In  Regulations,  No.  33,  issued  by  the  .Treasury  Department 
on  or  about  January  5,  1914,  provision  was  made  that  "in  cases 
wherein  there  is  an  annual  adjustment  of  book  values  of  securities,  real 
estate  and  like  assets,  and  the  increases  and  decreases  in  values  thus 
indicated  are  taken  up  on  the  books  and  reflected  in  the  profit  and  loss 
account,  such  readjusted  values  will  be  taken  into  account  in  making  the 
return  of  annual  net  income.  .  .  .  The  adjustment  referred  to  will 
comprehend  assets  which  have  increased  in  value  as  well  as  those  which 
have  decreased."  Article  134  also  contained  a  ruling  that  depreciation 
in  book  values  must  represent  an  actual  shrinkage  in  values  which  may 
be  determined  to  have  taken  place  during  the  year  for  which  the  return 
is  made. 

Treasury  Decision  2005,  dated  July  8,  1914,  reversed  the  foregoing 
rulings,  which  had  been  in  force  also  under  the  Corporation  Excise 
Tax  Law,  and  held  that  a  loss  to  be  deductible  must  be  an  absolute 
loss,  not  "a  speculative  or  fluctuating  valuation  of  continuing  invest- 
ment, but  must  be  an  actual  loss,  actually  sustained  and  ascertained 
during  the  tax  year  for  which  the  deduction  is  sought  to  be  made ;  it 
must  be  incurred  in  trade  and  be  determined  and  ascertained  upon  an 
actual,  a  completed,  a  closed  transaction." 

While  your  Committee  concedes  that  the  Treasury  Department  h'as 
good  authority  in  the  federal  courts  for  its  reversal  of  the  former  ruling 
and  for  its  present  contention  that  mere  changes  in  book  values  do  not 
constitute  either  loss  or  gain  until  there  is  liquidation,  yet  the  first  con- 
struction placed  upon  the  act  greatly  added  to  the  convenience  of  the 
taxpa3'er  in  making  his  return  of  net  income  and  resulted  in  substantial 
justice  to  the  government. 

A  merchant  is  permitted  to  make  annual  inventory  of  his  stock-in- 
trade  and  his  income  is  based  in  part  on  the  difference  between  the 
inventories  taken  at  the  beginning  and  at  the  end  of  the  year. 

Your  Committee  sees  no  reason  why  the  dealer  in  securities  or  in 
real  estate  or  in  any  other  species  of  property  should  not  justly  be  per- 
mitted to  determine  his  income  as  the  merchant  does.  Nor  can  it  con- 
ceive of  any  reason  why  the  investor,  whether  he  be  possessed  of  one 
piece  of  property  or  more,  should  not  come  within  the  same  rule. 

The  government  is  safeguarded,  since  a  marking  down  of  book 
values  in  one  year  will  necessarily  result  in  a  corresponding  increase 
in  future  years  or  when  the  property  is  sold,  if  at  the  close  of  the 
particular  transaction  there  should  be  a  gain. 

On  the  other  hand,  to  wait  until  the  transaction  is  closed  for  a  final 
accounting  burdens  the  investor  with  a  heavy  tax  for  the  year  in  which 


FEDERAL    INCOME    TAX  779 

the  property  is  sold,  adds  to  his  inconvenience  in  making  returns,  and 
results  only  in  a  rough  approximation  of  the  amount  of  tax  actually  due 
to  the  government.  To  one  who  deals  in  any  species  of  property  con- 
stantly, it  is  difficult  to  compute  with  any  degree  of  accuracy  the 
original  cost  of  each  item  sold  and  the  proportion  of  carrying  charges 
charged  to  it.  It  is  all  the  more  difficult  when  the  property  was  pur- 
chased many  years  before  the  incidence  of  the  tax  or  when  the  part 
sold  is  only  a  small  part  of  the  original  purchase. 

Real  estate  purchased  in  large  blocks  and  thereafter  subdivided  and 
sold  in  small  parcels  offers  difficulties  in  determining  the  gain  on  any 
particular  parcel  in  accordance  with  the  present  rulings  of  the  Treasury 
Department,  but  can  be  determined  with  ease  where  it  is  based  on  an 
annual  revaluation  of  the  whole  property. 

Since  the  present  method  of  computing  gains  on  sale  of  capital 
assets  results  in  annoyance  to  the  taxpayer  and  government  officials 
alike  and  approaches  the  taxable  gain  only  by  mere  approximation, 
while  the  inventory  method  is  logical,  convenient,  and  fair,  your  Com- 
mittee does  not  hesitate  to  urge  that  the  law  be  so  amended  that  in- 
ventory values  may  be  taken,  by  those  who  keep  books,  as  an  annual 
measure  of  the  gain  or  loss  in  the  value  of  unsold  assets  and  that 
returns  of  net  income  be  accepted  on  that  basis. 

In  order,  however,  to  safeguard  the  interests  of  the  Treasury  in 
case  of  reasonable  doubt  on  the  part  of  the  authorities,  as  to  the 
accuracy  or  good  faith  of  the  report,  it  may  be  just  as  well  to  guard 
against  the  possibility  of  abuse  by  some  proviso.  Your  Committee  would 
therefore  recommend  that : 

"Taxpayers  may  be  allowed  reasonably  to  revalue  their  assets  pro- 
vided that  in  case  of  doubt  the  administrative  authorities  may  ignore 
such  revaluation  and  postpone  the  reckoning  of  profit  or  loss  until  it  is 
actually  realized  by  sale,  complete  obsolescence,  or  some  similar  definite 
event." 

For  further  discussion  of  this  subject,  see  "Losses  on  Securities, 
etc.,"  page  795. 

Farmers 

A  farmer  is  not  required  to  return  as  income  that  part  of  his  crops 
which  is  consumed  as  food  by  himself  and  his  family.  To  that  extent 
he  is  receiving  an  allowance  for  living  expenses. 

The  government  has  issued  a  ruling  on  farm  accounting  which 
covers  the  subject  fully  and  is  reproduced  in  full: 

The  term  "Farm"  embraces  the  farm  in  the  ordinarily  accepted 
sense,  plantations,  ranches,  stock-farms,  poultry  farms,  dairy  farms, 
fruit  farms,  truck  farms,  and  all  lands  used  for  similar  purposes;  and 
for  the  purposes  of  this  Decision  all  persons  who  cultivate,  operate, 
or  manage  farms  for  gain  or  profit,  either  as  owners  or  tenants,  are 
designated  as  "Farmers." 

All  gains,  profits,  and  income  derived  from  the  sale  or  exchange 
of  farm  products,  whether  produced  on  the  farm,  or  purchased  and 
resold  by  a  farmer,  shall  be  included  in  the  return  of  income  for  the 
year  in  which  the  products  were  actually  marketed  and  sold ;  and  all 
allowable  deductions,  including  the  legitimate  expenses  incident  to 
the  production  of  that  year,  or  future  years,  may  be  claimed  in  the 


780  AUDITING 

return  of  income  for  the  tax  year  in  which  the  right  to  such  deductions 
shall  arise,  although  the  products  to  which  such  expenses  and  de- 
ductions are  incidental  may  not  have  been  sold  or  exchanged  for 
money,  or  a  money  equivalent,  during  the  year  for  which  the  return 
is  rendered. 

Rents  received  in  crop  shares  shall  likewise  be  returned  as  of  the 
year  in  which  the  crop  shares  are  reduced  to  money  or  a  money  equiva- 
lent, and  allowable  deductions,  likewise,  shall  be  claimed  in  the  return 
of  income  for  the  tax  year  to  which  they  apply,  although  expenses 
and  deductions  may  be  incident  to  products  which  remained  unsold 
at  the  end  of  the  year  for  which  the  deductions  are  claimed.  When 
farm  products  are  held  for  favorable  market  prices,  no  deduction  on 
account  of  shrinkage  in  weight  or  physical  value,  or  losses  by  reason 
of  such  shrinkage  or  deterioration  in  storage,  shall  be  allowed. 

Cost  of  stock  purchased  for  resale  is  an  allowable  deduction  undei 
the  item  of  expense,  but  money  expended  for  stock  for  breeding  pur- 
poses is  regarded  as  capital  invested,  and  the  amounts  so  expended 
do  not  constitute  allowable  deductions  except  as  hereinafter  stated. 

Where  stock  has  been  purchased  for  any  purpose,  and  afterwards 
dies  from  disease  or  injury,  or  is  killed  by  order  of  the  authorities 
of  a  state,  or  the  United  States,  and  the  cost  thereof  has  not  been 
claimed  as  an  item  of  expense,  the  actual  purchase  price  of  such  stock, 
less  any  depreciation  which  may  have  been  previously  claimed,  may 
be  deducted  as  a  loss.  Property  destroyed  by  order  of  the  authorities 
of  a  state,  or  of  the  United  States,  may,  in  a  like  manner,  be  claimed 
as  a  loss ;  but  if  reimbursement  is  made  by  a  state,  or  the  United  States, 
in  whole  or  in  part,  on  account  of  stock  killed  or  property  destroyed, 
the  amount  received  shall  be  reported  as  income  for  the  year  in  which 
reimbursement  is  made. 

The  cost  of  farm  machinery  is  not  allowable  deduction  as  an  item 
of  expense,  but  the  cost  of  ordinary  tools  may  be  included  under  this 
item. 

Farmers  who  keep  books,  according  to  some  approved  method  of 
accounting,  which  clearly  show  the  net  income,  may  prepare  their 
returns  from  such  books  although  the  method  of  accounting  may  not 
be  strictly  in  accordance  with  the  provisions  of  this  Decision. 

A  person  cultivating  or  operating  a  farm  for  recreation  or  pleasure, 
on  a  basis  other  than  the  recognized  principles  of  commercial  farm- 
ing, the  result  of  which  is  a  continual  loss  from  year  to  year,  is  not 
regarded  as  a  farmer.  In  such  cases,  if  the  expenses  incurred  in  con- 
nection with  the  farm  are  in  excess  of  the  receipts  therefrom,  the 
entire  receipts  from  sale  of  products  may  be  ignored  in  rendering  a 
return  of  income ;  and  the  expenses  incurred  being  regarded  as  per- 
sonal expenses  will  not  constitute  allowable  deductions  in  the  return 
of  income  derived  from  other  sources. 

Real  Estate 

As  heretofore  stated,  the  Department  takes  the  position  that  an 
investor  cannot  deduct  losses  arising  out  of  dealings  in  real  estate,  but 
that  one  in  the  real  estate  business  may  deduct  losses,  if  incurred. 

An  individual,  however,  must  report  gains  in  both  instances.  There- 
fore, unless  there  is  some  special  reason  for  so  doing,  it  is  not  advisable 
to  add  interest  as  a  carrying  charge. 


FEDERAL    INCOME    TAX  781 

Interest  is  an  allowable  deduction  year  by  year  for  the  full  amount 
paid,  and  by  claiming  the  deduction  the  tax  is  lowered.  If  added  to  the 
book  value  of  real  estate,  the  annual  deduction,  of  course,  cannot  be 
claimed.  When  sold  subsequently,  if  at  a  loss,  and  if  the  individual 
does  not  claim  or  is  not  permitted  to  claim  the  loss  as  a  deduction, 
then  the  entire  amount  of  interest  which  has  been  added,  and  which 
increases  the  loss  to  that  extent,  has  lost  its  identity  as  interest  and 
the  benefit  which  would  have  been  realized  if  claimed  annually  is  lost. 

The  Treasury  decision  on  this  point  is  as  follows : 

The  entire  profits  realized  by  individuals  or  corporations  from  the 
sale  of  real  estate  will  be  taxable  except  where  the  property  in  connec- 
tion with  which  the  profit  is  obtained  was  acquired  prior  to  March  1, 
1913,  in  the  case  of  individuals,  or  prior  to  January  1,  1909,  in  the  case 
of  corporations;  and  then  and  in  such  event  the  profit  will  be  pro- 
rated over  the  whole  time  the  property  was  held,  and  that  part  of  the 
whole  profit  apportioned  to  the  taxable  period  will  be  reported  in 
annual  returns  of  income.  In  prorating,  fractional  parts  of  years  will 
not  be  considered. 

For  income  tax  purposes,  where  there  is  an  actual  sale  and  transfer, 
profit  will  be  considered  as  realized  even  though  payment  is  to  be 
made  in  instalments,  as  notes  for  deferred  payments  are  secured  by 
the  title  to  the  property,  and  presumably  bear  interest  and  are  held  to 
be  worth,  in  cash,  their  face  value. 

In  case  of  default  on  instalment  payments  there  may  be  charged  off 
as  bad  debts  the  amount  of  such  unpaid  instalments  less  the  salvage 
value  of  the  real  estate  repossessed,     (T.  D,  2090,) 

Rents 
If  books  of  account  are  kept,  there  should  be  reported  all  rents 
collected  in  cash  as  well  as  those  accrued  and  which  are  believed  to  be 
collectable.  Any  items  found  to  be  uncollectable  can  be  deducted  as 
losses  in  subsequent  returns.  If  this  is  not  practicable  or  convenient, 
it  will  be  sufficient  to  report  all  rents  received  during  the  calendar  year. 

Interest 
All  interest  is  to  be  reported  whether  on  notes,  bank  deposits, 
securities,  bonds,  mortgages  or  deeds  of  trust,  or  other  similar  obliga- 
tions of  domestic  corporations,  joint-stock  companies  or  associations, 
and  insurance  companies,  bonds  issued  in  foreign  countries  or  upon 
foreign  mortgages  or  like  obligations  (not  payable  in  the  United 
States),  and  also  dividends  upon  the  stock  or  interest  upon  the 
obligations  of  foreign  corporations,  associations,  and  insurance  com- 
panies engaged  in  business  in  foreign  countries. 

Interest  on  Bank  Deposits 

Interest  on  bank  deposits  or  on  certificates  of  deposit,  whether 
paid  or  accrued  and  unpaid,  must  be  included  in  the  annual  income 


782 


AUDITING 


return   of  the   person   entitled   to    receive    such   interest,    whether    on 
open  account  or  on  the  certificate  of  deposit.     (Art.  67,  Reg.  33.) 

This,  no  doubt,  is  on  the  assumption  that  the  interest  is  credited 
promptly  and  in  fact  forms  part  of  the  individual's  cash  account  prior 
to  December  31.  If,  however,  the  taxpayer  does  not  receive  notice  of 
the  interest  until  after  his  cash  account  for  the  year  is  closed,  and  if 
he  is  reporting  upon  a  cash  as  distinguished  from  an  accrual  basis,  he 
would  not  be  required  to  include  the  interest  until  the  following  year. 

This  follows  the  ruling  that  interest  on  notes,  ordinary  mortgages, 
and  corporate  obligations  should  be  entered  on  the  annual  return  for 
the  year  in  which  such  payments  are  received. 

Annuities 

A  ruling  has  been  made  that  the  amount  received  under  a  life  insur- 
ance, endowment,  or  annuity  contract  is  not  income  when  returned  to 
the  person  making  the  contract,  either  upon  the  maturity  or  surrender 
of  the  contract ;  but  the  amount  by  which  the  sum  received  exceeds  the 
sum  paid  and  coming  into  the  hands  of  the  person  making  the  contract 
and  payment,  is  income. 

Perhaps  most  annuities  are  gifts,  in  which  case  this  ruling  would 
not  apply. 

So-called  dividends  on  life  insurance  policies  are  not  taxable  no 
matter  when  accrued  or  received. 

Non-Taxable  Interest 

The  law  provides,  "That  in  computing  net  income  under  this  section 
there  shall  be  excluded" : 

Interest  upon  the  obligations  of  a  state  or  any  political  subdivision 
thereof,  and  upon  the  obligations  of  the  United  States  or  its  possessions. 

Where  a  municipality  purchases  a  public  utility  subject  to  a  mort- 
gage, the  mortgage  retains  its  original  character,  even  though  the 
municipality  assumes  the  mortgage  indebtedness  and  pays  the  interest 
thereon.  Therefore,  the  indebtedness  secured  by  such  mortgage  is  not 
an  obligation  of  the  municipality  within  the  meaning  of  paragraph  B 
of  the  income  tax  law.     (T.  D.  2090.) 

Special  assessment  districts  created  under  the  laws  of  the  several  states 
for  public  purposes,  such  as  the  improvement  of  streets  and  public 
highways,  the  provision  for  sewerage,  gas,  and  light,  and  the  reclama- 
tion, drainage,  or  irrigation  of  bodies  of  land  within  such  special 
assessment  districts  when  such  districts  are  for  public  use,  are  political 
subdivisions  of  the  state  within  the  meaning  of  the  above  proviso. 

It  is  held  that  the  term  "political  subdivision"  includes  special  as- 
sessment districts  or  divisions  of  a  state  created  by  the  proper  authority 
of  the  state  acting  within  its  constitutional  powers  and  under  its  gen- 
eral laws,  for  the  purpose  of  carrying  out  a  portion  of  those  functions 
of  the  state  which  by  long  usage  and  inherent  necessities  of  government 
have  always  been  regarded  as  public. 


FEDERAL    INCOME    TAX 


783 


Levee  and  school  districts,  when  lawfully  created  under  the  authority 
of  the  state  and  which  are  authorized  by  the  laws  of  the  state  to  levy 
a  tax  to  meet  the  obligations  of  such  districts,  are  also  held  to  be 
political  subdivisions  of  a  state  within  the  meaning  of  the  income  tax 
law. 

The  income  derived  from  interest  upon  the  obligations  of  all  such 
public  districts  shall,  therefore,  be  excluded  in  computing  net  income 
for  the  income  tax.     (T.  D.  1946.) 

Partnership   Gains  and   Profits,  Whether  Distributed  or  Not 

The  law  is  that  any  persons  carrying  on  business  in  partnership  shall 
be  liable  for  income  tax  only  in  their  individual  capacity,  and  the  share 
of  the  profits  of  a  partnership  to  which  any  taxable  partner  would  be 
entitled  if  the  same  were  divided,  whether  actually  divided  or  other- 
wise, shall  be  returned  for  taxation  and  the  tax  paid,  under  the  pro- 
visions of  this  section;  and  any  such  firm,  when  requested  by  the 
Commissioner  of  Internal  Revenue,  or  any  district  collector,  shall  for- 
ward to  him  a  correct  statement  of  such  profits  and  the  names  of  the 
individuals  who  would  be  entitled  to  the  same,  if  distributed.  T.  D, 
2137  provides  that  the  individual  members  of  a  partnership  firm  shall 
include  in  their  individual  returns  of  income  to  be  filed  on  Form  1040 
revised,  for  the  calendar  year  1914,  their  respective  distributive  interests 
in  the  partnership's  profits  ascertained  for  the  business  year  ending  on 
any  date  in  1914. 

The  regulations  provide : 

Partnerships,  as  such,  are  not  subject  to  the  income  tax,  and  are 
only  required  to  make  return  when  requested  to  do  so  by  the  Com- 
missioner of  Internal  Revenue  or  the  collector  of  internal  revenue  for 
the  district  in  which  said  partnership  has  its  principal  place  of  business ; 
and  when  a  return  is  required  it  shall  give  a  complete  and  correct 
statement  of  the  gross  income  of  the  said  partnership  and  also  a 
complete  statement  of  the  actual  expenses  of  conducting  the  business 
of  said  partnership,  and  the  net  profits  and  the  name  and  address  of 
each  member  of  said  partnership,  and  their  respective  interest  in  the 
net  profit  thus  reported. 

The  net  annual  profits  of  a  partnership  when  divided  and  paid 
to  the  members  thereof  shall  be  included  by  each  individual  partner 
receiving  same  in  his  annual  return  of  net  mcome,  and  the  tax  shall 
be  paid  thereon  as  required  by  law.  When  the  annual  profits  of  a 
partnership  are  not  distributed  and  paid  to  the  members  thereof,  the 
respective  interest  of  each  member  in  said  profits  shall  be  ascertained, 
and  the  individuals  entitled  thereto  shall  include  the  said  amount  in 
their  annual  return  as  a  part  of  their  gross  income,  the  same  as  if 
said  profits  had  been  distributed  and  paid  to  them. 

It  is  clear  that  a  partnership  having  a  fiscal  or  closing  period  other 
than  December  31  need  not  attempt  to  make  an  additional  closing  of 
the  books  or  ascertainment  of  profits  or  losses  at  December  31  in  order 


784  AUDITING 

that  the  individual  members  of  the  partnership  may  return  their  share 
of  the  net  profits  or  losses  of  the  partnership  for  the  calendar  year. 

It  is  recognized  that  it  is  frequently  impossible  to  close  the  books 
of  a  partnership  on  December  31  ;  in  fact,  the  last  day  of  various  other 
months  is  usually  the  most  convenient  date  for  ascertaining  accurately 
the  financial  condition  and  the  gains  or  losses  of  a  partnership. 

What  the  government  does  want,  and  should  have,  from  an  individ- 
ual who  is  a  partner  in  one  or  more  firms,  is  a  full  and  accurate  return 
of  his  share  of  the  partnership  profits  for  the  twelve  months  ending 
at  some  date  during  the  calendar  year.  This  will  obviate  the  necessity 
of  guessing,  or  calculating  upon  incomplete  data,  on  one's  income 
where  the  fiscal  year  of  the  partnership  does  not  end  December  31.  It 
makes  it  convenient  and  accurate  to  report  the  amount  shown  by  the 
partnership  records,  and  as  the  income  tax  has  come  to  stay,  the  gov- 
ernment will  not  lose  any  possible  income  through  the  postponement 
of  the  reporting  of  possible  profits  realized  during  the  period  between 
the  usual  closing  date  and  December  31. 

To  illustrate:  An  individual  member  of  a  partnership  which  closes 
its  fiscal  year  October  31.  if  he  has  no  other  source  of  income,  will 
report  the  aggregate  distributive  share  of  the  partnership  profits  to 
which  he  was  entitled  for  the  fiscal  year  ended  October  31,  as  shown 
by  the  books  (and  assuming  their  accuracy),  whether  drawn  out  or 
left  in  the  business. 

His  individual  return  being  made  as  of  December  31.  it  may  be 
that  during  the  months  of  November  and  December  the  partnership 
made  a  profit  to  a  share  of  which  he  is  entitled,  but  so  long  as  the 
books  are  not  closed  December  31.  and  the  results  of  the  business 
ascertained  and  stated,  no  report  is  required  of  the  operations  of  those 
two  months,  because  in  his  next  return  the  individual  will  report  his 
full  distributable  share  of  the  profits  for  the  full  fiscal  year  ending 
October  31,  which,  of  course,  will  include  the  results  of  the  operations 
of  the  business  for  the  months  of  November  and  December  in  the 
preceding  year. 

Dividends   and   Interest   Received  by  Partnerships 

At  least  one  of  the  collectors  of  internal  revenue  holds  that  income 
accruing  to  a  partnership  loses  its  identity,  and,  as  credited  or  dis- 
tributed to  the  partners,  is  all  taxable,  although  the  law  expressly  ex- 
empts interest  on  government  bonds,  etc.,  and  dividends  up  to  $20,000. 

The  Treasury  Department  itself  does  not  si'jtain  this  position  so 
far  as  interest  is  concerned.  The  Deputy  Commissioner  of  Internal 
Revenue  on  April  22,  1915,  wrote  as  follows : 

This    office    acknowledges    receipt    of   your    letter    asking    whether 


FEDERAL    INCOME    TAX 


785 


partnerships  are  allowed  to  deduct  from  their  gross  income,  in  ascer- 
taining the  distributive  interests  of  individual  members,  the  "total 
amount  of  interest  received  upon  obligations  of  a  state  or  political 
subdivision  thereof,  and  upon  the  obligations  of  the  United  States  or 
its  possessions." 

You  point  out  that  this  deduction  was  provided  for  by  item  (e), 
page  1,  of  office  Form  1065. 

In  reply  you  are  advised  that  partnerships  are  permitted,  in  a 
computation  of  their  net  incomes  for  the  purpose  of  ascertaining  the 
distributable  interests  of  partnership  members,  to  deduct  the  item 
quoted  by  you. 

There  seems  to  be  no  justification  for  the  position  of  the  collector, 
and  it  is  likely  to  be  so  decided  by  the  courts.  In  the  meantime, 
unfortunately  a  large  amount  of  tax  has  been  paid  under  his  ruling. 
It  would  appear  to  be  a  compliance  with  the  law  for  a  partner  to 
analyze  his  share  of  firm  profits  and  segregate  the  interest  on  United 
States,  state,  and  municipal  bonds,  etc.,  and  dividends.  The  interest 
should  be  omitted  entirely  from  his  returns,  and  dividends  should  be 
entered  on  the  line  provided  therefor. 

If  it  is  felt  that  notice  should  be  given  to  the  government  that  the 
return  follows  the  law  rather  than  the  regulations,  then  the  amount 
of  such  interest  and  dividends  should  be  stated  in  short  with  an  ex- 
planatory note.  If  the  taxpayer  is  assessed  thereon,  the  tax  should 
be  paid  under  protest.  A  decision  on  this  point  will  no  doubt  be  made 
by  the  courts  and,  if  the  author's  position  is  sustained,  a  refund  can 
be  secured. 

The  Commissioner  of  Internal  Revenue,  in  his  report  of  December 
6,  1915,  recommended  that  partnerships  be  required  to  report  on  the 
basis  now  required  of  corporations. 

Royalties  from  Mines,  Oil  Wells,  Patents,  Franchises, 
or    Other    Legalized    Privileges 

In  the  case  of  mines  operated  by  a  lessee  on  a  royalty  basis,  it  is 
held  that  the  lessor  in  disposing  of  his  ores  or  natural  deposits  on  the 
basis  of  royalties  has  a  measure  of  profit  in  every  ton  of  ore  disposed 
of  in  this  way,  and  that  so  much  of  the  gross  receipts  on  account  o'f 
royalties  as  is  in  excess  of  depletion,  not  exceeding  5  per  cent  of 
the  gross  value  of  the  output  at  the  mine,  plus  any  incidental  expenses 
to  which  the  corporation  may  be  subject,  is  income  within  the  mean- 
ing of  the  federal  income  tax  law  and  should  be  so  returned  by  the 
lessor. 

Other  Sources  of  Income 

Property  Acquired  by  Gift 

The  value  of  property  acquired  by  gift  is  not  subject  to  income  tax, 
but  all  gains,  profits,  or  income  derived  therefrom  are  subject  to  tax, 


786  AUDITING 

and  if  the  property  so  acquired  is  subsequently  sold  at  a  price  greater 
than  the  appraised  value  at  the  time  the  property  was  acquired  by 
gift,  the  gain  in  value  is  held  to  be  income  and  subject  to  tax  under 
the  provisions  of  the  federal  income  tax  law.     (T.  D.  2090.) 

Proceeds  of  Sale  of  Rights  to  Subscribe  to  Stock 

The  income  tax  law  levies  the  tax  upon  income  accruing  from  all 
sources  and,  under  these  circumstances,  it  is  held  by  this  office  that 
income  accruing  to  an  individual  who  holds  stock  in  a  corporation  by 
reason  of  the  sale  of  his  rights  to  subscribe  to  new  stock  in  the  cor- 
poration, is  such  an  item  of  income  as  should  be  included  in  his  return 
of  annual  net  income  for  the  assessment  of  the  tax.  (Extract  from  a 
letter  signed  by  Deputy  Commissioner  L.  F.  Speer  and  dated  February 
21,  1915.) 

Accident  Insurance 

Money  paid  to  the  person  insured  by  an  accident  insurance  policy 
on  account  of  accident  sustained,  is  returnable  as  gross  income  by  the 
insured  person.  The  proceeds  of  accident  insurance  policies  paid  to 
the  beneficiaries  upon  the  death  of  the  person  insured  are  to  be  treated 
like  the  proceeds  of  life  insurance  policies. 

Dividends 

Dividends  on  stock  or  from  the  net  earnings  of  domestic  corpora- 
tions, joint-stock  companies,  associations,  or  insurance  companies  sub- 
ject to  like  tax,  are  not  subject  to  the  normal  tax.  See  rules  as  to 
reporting    page  772. 

Stock  Dividends 

Stock  dividends  when  required  to  be  included  in  a  return  of  income 
should  be  accounted  for  at  the  valuation  placed  upon  the  stock  by 
the  corporation  when  said  stock  dividends  were  issued.     (T.  D.  2090.) 

Stock  dividends  issued  as  a  bona  fide  and  permanent  increase  of  the 
capital  stock  of  corporations,  etc.,  without  intent  to  evade  the  imposi- 
tion of  the  personal  income  tax,  are  held  to  represent  capital;  and 
are  not,  therefore,  subject  to  the  income  tax  as  gains,  profits,  and  in- 
come in  the  hands  of  the  stockholder. 

If,  however,  the  dividend  stock  should  be  surrendered  to  the  cor- 
poration for  cash  or  its  equivalent,  or  if  the  assets  of  the  corporation 
in  any  manner  should  be  distributed  by  means  of  the  stock  dividend, 
the  amount  realized  will  be  considered  income  for  the  year  when  so 
converted  or  received,  and  will  be  returned  as  income  by  the  corporation 
or  individual  receiving  the  same. 

T.  D.  2274,  dated  December  22,  1915,  modifies  former  decisions,  and 
reads  as  follows : 

Stock  dividends  paid  from  the  net  earnings  or  the  established  sur- 


FEDERAL    INCOME    TAX  787 

plus  or  undivided  profits  of  corporations,  joint-stock  companies  or  asso- 
ciations, and  insurance  companies,  are  held  to  be  the  equivalent  of 
cash,  and  to  constitute  taxable  income  under  the  same  conditions  as 
cash  dividends. 

In  view  of  court  decisions  in  various  jurisdictions,  it  is  not  likely 
that  the  broad  rule  here  laid  down  will  remain  unchallenged. 

Scrip  Dividends 

Inasmuch  as  scrip  dividends  arc  issued  only  by  corporations  unable 
to  pay  cash,  there  is  a  serious  doubt  as  to  whether  such  scrip  is  worth 
its  face  value  in  cash  and  can  be  taxed  on  such  a  basis. 

Life  Insurance 

Dividends  paid  on  life  insurance  policies  that  have  not  matured, 
whether  such  dividends  are  drawn  in  cash  by  the  insured  or  applied 
to  the  reduction  of  the  annual  premium  due,  are  not  considered  items 
of  taxable  income  under  the  law,  and  should  be  excluded  from  a  return 
of  income. 

The  same  rule  applies  to  dividends  declared  on  endowment  and 
other  policies  but  not  paid  to  policyholders  until  the  maturity  of  the 
contracts. 

Dividends  from  paid-up  policies,  however,  are  considered  income 
to  the  recipient,  and  must  be  included  in  the  annual  return  of  income 
whenever  the  taxpayer's  income,  including  such  dividends,  is  in  ex- 
cess of  $20,000.  They  are  considered  the  same  as  dividends  or  net 
earnings  from  corporations  subject  to  a  like  tax,  and  may  therefore 
be  excluded  from  a  return  of  income  in  cases  where  the  income  is 
subject  to  the  normal  tax  of  1  per  cent  only. 

Cash  Dividends;  Time  of  Receipt  Governs,  Not  When  Declared 

The  Bureau  of  Internal  Revenue  holds  that : 

Cash  dividends,  or  their  equivalent,  paid  from  the  net  earnings,  or 
the  established  surplus  or  undivided  profits  of  corporations,  joint-stock 
companies,  or  associations  and  insurance  companies,  if  declared  and 
paid  on  or  after  March  1,  1913,  constitute  taxable  income  in  the  hands 
of  shareholders  or  beneficiaries  when  received,  and  should  be  returned 
when  the  total  net  income  of  any  individual  is  in  excess  of  $20,000, 
inclusive  of  such  dividends,  and  the  additional  tax  should  be  paid 
thereon  as  on  income  for  the  year  in  which  such  dividends  were  re- 
ceived, without  regard  to  the  period  in  which  the  profits  or  surplus 
were  earned  or  the  period  during  which  they  were  carried  as  surplus 
or  undivided  profits  in  the  treasury  or  on  the  books  of  the  corpora- 
tions, etc. 

Therefore,  dividends  received  by  an  individual  after  March  1,  1913, 
although  obviously  paid  out  of  earnings  prior  thereto,  are  taxable  so  far 


^88  AUDITING 

as  the  present  rulings  apply.  On  October  19,  1915,  it  was  ruled  (in  con- 
nection with  a  distribution  of  profits  in  1913,  accumulated  during  a 
period  of  several  years  prior  thereto)  that  "the  dividends  in  question, 
being  a  distribution  in  1913  of  corporate  profits,  had  the  status  of  income 
for  income  tax  purposes  to  the  stockholders  of  the  corporation." 

And,  again,  on  November  30,  1915,  the  Commissioner  of  Internal 
Revenue,  in  passing  upon  the  following  facts : 

The  X  corporation  is  compelled  to  liquidate  by  mandatory  statute 
of  the  state  in  which  it  is  incorporated. 

The  major  part  of  its  surplus  which  is  thus  compelled  to  be  dis- 
tributed to  its  stockholders  was  accumulated  prior  to  March  1,  1913. 

This  distribution  is  not  made  as  dividends  paid  by  a  going  concern, 
but  as  a  pro  rata  distribution  of  the  assets  of  the  company  upon  dissolu- 
tion. 

The  stockholders  have  remained  the  same  since  incorporation. 

Is  the  fund  accumulated  prior  to  March  1,  1913,  thus  distributed, 
subject  to  income  tax  to  the  individuals  who  receive  it? 

ruled  as  follows: 

It  is  held,  under  the  provisions  of  Treasury  Decision  2163  of  Febru- 
ary 18,  1915,  that  a  surplus  representing  the  net  earnings  of  a  corpora- 
tion, regardless  of  the  period  during  which  earned,  is  subject  to  the 
income  tax  as  dividends  when  distributed,  whether  by  declaration  of 
dividends  or  otherwise,  if  the  distribution  was  authorized  on  or  after 
March  1,  1913. 

The  government  evidently  takes  the  position  that  "once  profit,  always 
profit"  and  does  not  recognize  the  usual  differentiation  between  princi- 
pal and  income.  The  accountant  is  as  careful  to  separate  one  from 
the  other  in  calculating  the  profit  of  an  individual  as  in  stating  the 
profit  of  a  corporation,  but  having  made  the  calculation  and  stated 
the  accounts,  he  has  always  understood  that  the  undivided  income  or 
profit  merged  with  the  principal  or  capital  and  that  thereafter  the  new 
calculation  of  income  would  be  upon  one  principal  sum  only. 

Under  this  theory  an  individual  may,  on  March  1,  1913,  have  had 
capital  as  shown  by  his  books  of  $1,000,000,  but  all  of  it  except  a  very 
small  part  may  have  been  the  accumulation  of  undivided  profits  over  a 
long  period  of  years.  If  he  took  in  a  partner  on  March  1,  1913,  or  if 
he  incorporated  his  business  at  that  time,  surely  it  would  be  recognized 
that  the  entire  $1,000,000  constituted  capital  and  not  part  capital  and 
mostly  income. 

So  with  a  corporation  as  to  its  surplus.  At  the  end  of  any  fixed 
period  its  profits  or  losses  are  determined.  If  the  profits  are  not  all 
paid  out  in  dividends  but  are  allowed  to  accumulate,  the  net  worth  of 
the  corporation,  composed  of  capital  stock  and  surplus,  is  all  capital 
thereafter  in  every  respect,  save  one,  i.e.,  the  corporation  laws  permit 


FEDERAL    INCOME    TAX 


789 


subsequent  declarations  of  dividends  up  to  the  whole  of  the  surplus. 
This,  however,  is  in  the  nature  of  a  penalty  clause  more  than  anything 
else.  It  merely  prohibits  directors  from  paying  out  in  dividends  any 
part  of  the  capital  stock,  and  permits  the  payment  of  all  accumulations 
irrespective  of  when  earned. 

The  law  purports  to  tax  only  "gains,  profits,  and  income"  after 
March  1,  1913.  Before  that  date  the  tax  would  have  been  unconstitu- 
tional. If  the  earnings  of  an  individual  prior  thereto  became  principal 
on  that  date,  or  for  any  other  reason  were  not  taxable,  surely  the 
surplus  of  a  corporation  on  that  date  was  principal  as  related  to  gains, 
profits,  and  income,  and  an  individual  receiving  a  portion  of  such 
fund,  all  earned  prior  to  March  1,  1913,  cannot  equitably  be  taxed 
thereon  on  the  same  basis  as  income  earned  subsequently  to  the  date 
when  a  tax  upon  incomes  became  constitutional.  If  it  can,  accountants 
will  have  to  evolve  a  new  theory  of  principal  and  income. 

In  the  preparation  of  returns,  attention  should  be  given  to  the 
point  as  to  whether  or  not  items  theretofore  returned  as  dividends 
(where  the  total  exceeded  $20,000)  were  subsequently  found  to  be,  in 
fact,  out  of  capital.  If  so,  a  deduction  should  be  made  in  subsequent 
returns  or  claim  filed  for  rebate. 

For  a  full  discussion  of  this  point,  see  Journal  of  Accountancy 
for  November,  1915,  page  370,  et  seq. 


ALLOWABLE  DEDUCTIONS  TO  INDIVIDUALS 

Most  individuals  find  it  easier  to  recall  all  of  the  items  of  their  in- 
come than  of  their  expenditures,  and  for  this  reason  it  has  been  found 
that  advantage  has  not  been  taken  of  many  allowable  deductions. 

The  professional  accountant  should  carefully  study  the  provisions  of 
the  law  bearing  on  this  point  and  be  prepared  to  pass  on  the  propriety 
of  including  or  excluding  the  various  items  of  expenditure  which  are 
found  or  are  known  to  have  been  made  by  clients. 

Taking  up  the  allowable  deductions  in  their  order,  the  first  item  is 
that  of  expenses. 

Expenses 

The  provision  of  the  law  is  as  follows : 

The  amount  of  necessary  expenses  actually  paid  within  the  calendar 
year  for  which  the  return  is  made,  in  carrying  on  any  individual 
business.  There  must  not  be  included  under  this  head,  personal,  living, 
or  family  expenses,  business  expenses  of  partnerships,  or  cost  of  mer- 
chandise. Amounts  paid  for  permanent  improvement  or  betterment  of 
property  are  not  proper  expense  deductions. 

Perhaps  the  best  method  of  determining  the  items  properly  applicable 


790 


AUDITING 


under  this  head  is  to  arrive  at  them  negatively,  that  is,  to  ascertain 
the  amounts  paid  for  personal,  living,  or  family  expenses  (items  which 
are  not  deductible),  and  stating  the  balance  of  one's  payments  as  busi- 
ness expenses.  This  method  would  not  find  favor  with  the  taxing 
authorities  and  is  not  suggested  as  a  feasible  plan  to  adopt.  It  is, 
however,  illustrative  of  one  means  whereby  permissible  deductions  may 
be  discovered. 

For  instance,  T.  D.  2137  states  that  expenses  incurred  in  earning 
income  which  is  not  subject  to  tax  under  the  income  tax  law  do  not 
constitute  allowable  deductions  in  computing  net  income  from  other 
sources  which  are  taxable  under  the  law. 

This  properly  indicates  that  if  one's  income  (salary,  or  other  com- 
pensation or  earning)  is  taxable,  then  the  expenses  incurred  in  earn- 
ing it  are  allowable  deductions.  For  instance,  a  clerk  may  receive  a 
salary  of  $5,000  per  annum.  The  author's  interpretation  of  the  law  is 
to  apply  the  query,  "what  would  his  personal,  living,  or  family  ex- 
penses be  if  his  income  of  $5,000  were  derived  from  investments?"  If 
he  lives  out  of  town  and  pays  $20  per  month  railroad  fare,  he  should 
be  permitted  to  deduct  $240  per  annum  for  this  item.  If  in  order  to 
earn  his  salary  he  must  purchase  books,  attend  lectures,  and  incur  sim- 
ilar expenses,  they  are  proper  deductions.  If  he  must  belong  to  a 
luncheon  club  and  entertain  at  his  own  expense  prospective  or  actual 
customers  or  clients,  the  dues  and  other  charges  of  the  club  are  busi- 
ness expenses  and  allowable  deductions. 

It  must  be  remembered  that  no  differentiation  of  income  is  found  in 
the  law.  In  other  countries  an  "earned"  income  is  taxable  at  a  lower 
rate  than  one  derived  from  investments.  Those  in  receipt  of  "earned" 
incomes  lose  this  advantage  under  our  law,  but  there  is  no  reason  at 
all  why  they  should  be  placed  under  the  additional  disadvantage  of 
having  to  incur  expenses  of  a  business  nature  (from  which  they  would 
be  free  if  they  were  out  of  business)  and  then  not  be  permitted  to 
deduct  such  expenses  in  arriving  at  net  income. 

If  one  is  a  university  professor  and  must  purchase  books  and  incur 
similar  expenses  in  order  to  maintain  his  standing,  such  items  are 
allowable  deductions.  Of  course  one  should  not  split  hairs,  but  inter- 
preting the  law  and  the  regulations  from  a  combined  theoretical  and 
reasonable  point  of  view,  it  is  well  to  know  the  exact  rights  thereunder 
as  well  as  the  exact  obligations.  It  was  the  author's  purpose  in  defining 
the  extreme  limit  of  reportable  income,  to  mention  every  dollar  of 
taxable  income  to  which  the  government  is  entitled,  and  it  naturally 
follows  that  every  item  of  allowable  deduction  should  likewise  be 
mentioned. 

The  average  citizen  of  the  United  States  is  not  given  to  a  close 
analysis  of  his  personal  expenditures.    Anything  which  tends  to  increase 


FEDERAL    INCOME    TAX 


791 


the  number  of  those  who  record  and  thus  know  where  their  income 
goes,  will  in  the  long  run  increase  the  government's  revenue  from  the 
income  tax,  because  the  almost  invariable  result  of  a  close  watch  over 
one's  expenditure  is  a  cutting  out  of  extravagant  and  foolish  items 
and  a  consequent  increase  of  savings,  and  subsequent  income  from  the 
investment  thereof. 

Therefore  it  is  believed  that  the  Commissioner  of  Internal  Revenue 
and  his  successors  will  not  look  with  disfavor  upon  certain  deductions 
herein  suggested,  which  in  themselves  might  indicate  a  purpose  to 
evade  taxation. 

Various  items  officially  passed  upon  are  cited  as  illustrative  of  allow- 
able deductions.  So  long  as  good  faith  is  observed  in  the  inclusion  of 
an  expense  item,  it  is  not  likely  to  be  objected  to. 

Professional  Expenses 

Many  lawyers,  doctors,  and  other  professional  men  keep  fairly 
accurate  records  of  income,  but  are  not  careful  to  separate  personal  and 
living  expenses  from  those  incurred  in  connection  with,  or  necessary 
to  produce,  their  income.  If  care  is  taken  to  assemble  all  items  of 
taxable  income,  then  equal  care  should  be  given  to  compile  a  schedule 
of  allowable  deductions  from  income. 

Where  a  medical  practitioner  has  his  office  apart  from  his  house, 
the  items  of  expenses  are  more  readily  determined,  but  the  principle 
is  the  same.  The  expenses  incident  to  the  earning  of  income  are  the 
ones  to  be  ascertained.  Thus  a  physician  whose  city  office  is  in  his 
house  and  who  also  practices  from  his  country  house,  should  deduct 
part  of  the  depreciation,  repairs,  etc.,  of  both  houses ;  all  or  part  of  the 
depreciation  and  maintenance  of  automobiles  or  horses;  depreciation 
of  books,  instruments,  office  furniture,  etc.  In  addition  thereto,  there 
will  be  various  payments  for  subscriptions  to  medical  journals,  dues 
of  professional  societies,  and  many  other  items  incident  to  his  pro- 
fessional work  and  which  would  not  be  incurred  if  he  were  not  in 
practice.  In  other  words,  the  law  attempts  to  tax  net  income  only,  and 
every  item  of  expenditure  which  affects  or  stimulates  or  helps  earn  the 
income  is  an  allowable  deduction. 

Premium  on  Fidelity  Bond 

Where  an  employee  is  required  to  furnish  bond  and  pay  the  premium 
on  such  bond,  as  a  necessary  incident  of  his  employment,  the  premium 
on  the  bond  will  constitute  an  allowable  deduction  in  computing  net 
income.     (T.  D.  2090.) 

Commissions  Paid  Real  Estate  Agents 

A  commission  paid  to  a  real  estate  agent  for  collecting  rents  and 


792  AUDITING 

for  management  of  property  is  a  legitimate  business  expense  and  con- 
stitutes an  allowable  deduction  in  computing  net  income.     (T.  D.  2090.) 

Commissions  Paid  to  Salesmen 

Commissions  paid  to  salesmen  as  a  part  of  the  expense  of  con- 
ducting business  are  allowable  deductions  to  the  payer  of  the  commis- 
sion.    (T.  D.  2090.) 

Taxes  Paid  by  a  Tenant 

Taxes  paid  by  a  tenant  for  a  landlord  are  considered  as  additional 
payment  for  rent  and  are  deductible  as  an  expense  of  carrying  on 
business.     (T.  D.  2090.) 

Life  and  Fire  Insurance  Premiums 

Premiums  paid  for  insurance  on  property  which  is  not  occupied  by 
the  owner  as  a  dwelling,  but  is  rented  or  leased  to  secure  an  income, 
constitute  allowable  deductions  in  computing  net  income. 

Premiums  paid  on  life  insurance  by  the  insured  do  not  constitute 
allowable  deductions  under  the  income  tax  law.     (T.  D.  2090.) 

Life   Insurance   Carried   by   Partnership   on   Lives   of   Individual 
Members 

Premiums  paid  on  life  insurance  taken  out  by  a  partnership  upon 
the  lives  of  individual  members  of  such  partnership,  constitute  allow- 
able deductions  in  ascertaining  the  net  earnings  of  the  partnership. 
However,  when  such  policies  mature,  or  upon  the  death  of  the  insured 
partner,  the  amount  received  as  life  insurance  should  be  included  in 
the  gross  income  of  the  partnership.     (T.  D.  2090.) 

Rent 

An  application  under  the  British  income  tax  act,  by  a  clergyman 
for  the  deduction  of  the  rental  value  of  his  study  from  his  income 
(which  was  granted),  may  be  cited  as  an  interesting  British  precedent. 
(See  Murray  &  Carter's  "A  Guide  to  Income  Tax  Practice,"  6th  Ed., 
page  268,  London,  1911.) 

Management  Expenses 

On  this  point  the  report  to  the  National  Tax  Association  says : 

Expenses  Incurred  by  Indiviituals  in  Making  Investments  and 
Managing  Property,  with  Respect  to  Which  the  Income  is 
Taxed,   Should  be  Permitted  as  are  Expenses  of  Carrying  on 

Business. 

The  act  allows  the  deduction  of  the  necessary  expenses  actually 
paid  in  carrying  on  any  business,  not  including  personal,  family,  or 
living  expenses.  This  leaves  a  doubt  as  to  expenses  incurred  in  man- 
aging property  held  for  investment  (insurance,  commissions  for  collect- 
ing rents,  repairs,  etc.).  Such  management  is  not  commonly  regarded 
as  carrying  on  a  business;  neither,  however,  are  the  expenses  of  man- 


FEDERAL    INCOME    TAX 


793 


agement  personal,  family,  or  living  expenses.  It  would  be  easy  to  set 
this  matter  clear.  Management  expenses  should  be  treated  like  business 
expenses. 

Interest 

The  next  classification  of  allowable  deductions  is  interest.  The  law 
provides  for:  "All  interest  paid  within  the  year  on  personal  indebted- 
ness of  taxpayer." 

The  regulations  published  in  1915  provided  that  the  deduction  under 
this  item  should  be :  ''All  interest  paid  within  the  year  on  personal 
indebtedness  of  the  taxpayer  incurred  in  the  conduct  of  business."  Note 
the  last  six  words,  which  are  not  found  in  the  law.  As  the  law  reads 
it  is  perfectly  clear.  Manifestly  it  was  intended  that  if  an  individual 
should  buy  a  house  for  $10,000  subject  to  an  $8,000  6  per  cent  mort- 
gage, he  could  claim  an  allowable  deduction  of  $480  per  year.  True, 
such  a  provision  is  not  equitable  as  against  an  individual  who  pays 
rent  but  who  cannot  include  such  payment  as  a  deduction.  Therefore, 
the  Commissioner,  while  completely  rewriting  the  law  by  adding  words 
which  changed  its  meaning,  may  have  endeavored  to  collect  additional 
revenue  from  those  who  should  have  paid  it ;  yet  by  so*  doing  he  com- 
pletely usurped  legislative  powers.  Later,  the  regulations  were  in  effect 
changed  by  a  telegram  sent  to  a  firm  of  lawyers.  The  lawyers  tele- 
graphed the  Commissioner  as  follows : 

Article  6  of  the  Regulations  of  January  5,  1915,  in  referring  to 
deductions  from  individual's  income  permits  the  deduction  of  interest 
"paid  within  the  year  on  personal  indebtedness  of  the  taxpayer,  in- 
curred in  the  conduct  of  business."  Do  we  understand  that  the  De- 
partment does  not  allow  deduction  of  interest  unless  incurred  in  the 
conduct  of  business?  .  .  . 

The  Commissioner  replied : 

Your  telegram  February  11  received.  All  interest  paid  within  the 
year  by  taxable  persons  on  indebtedness  may  be  deducted  in  computing 
net  income. 

It  would  be  interesting  to  know  how  much  revenue  the  government 
collected  through  this  mistaken  regulation,  and  whether  any  effort  was 
made  to  advise  individuals  who  may  have  followed  the  regulations 
that  they  were  in  error. 

This  is  a  good  illustration  of  the  fallibility  of  Treasury  Department 
regulations  and  decisions,  and  emphasizes  the  necessity  of  understand- 
ing the  law  and  insisting  upon  its  being  enforced.  If  no  objection  had 
been  made  in  the  case  in  point  it  is  quite  probable  that  the  govern- 
ment would  have  continued  to  collect  taxes,  to  which  it  was  not 
entitled,  from  unsuspecting  individuals. 


794 


AUDITING 


It  would  seem  that  a  proper  and  equitable  provision  in  the  law  would 
be  to  permit  the  deduction  of  interest  payments  only  where  the  interest- 
bearing  debt  was  incurred  in  the  purchase  of  property  or  investments 
for  income-producing  purposes. 

Taxes 

The  next  item  covers  taxes.  The  law  provides  that  there  may  be 
deducted  :  "AH  national,  state,  county,  school  and  municipal  taxes  paid" 
within  the  year  (not  including  those  assessed  against  local  benefits). 

As  the  taxes  paid  upon  an  individual's  residence,  the  rental  value 
of  which  is  not  taxable,  are  an  allowable  deduction,  it  would  seem 
to  be  more  equitable  if  taxes  were  deductible  only  when  paid  in  re- 
spect of  income-producing  property,  or  property  acquired  for  income- 
producing  purposes. 

Taxes  paid  by  citizens  or  resident  aliens  of  the  United  States  to  a 
foreign  country  are  not  allowable  deductions  in  computing  net  income. 
The  provision  of  law  for  the  deduction  of  taxes  applies  only  to  taxes 
paid  to  the  United  States,  or  to  some  state  or  political  subdivision 
thereof  in  the  United  States.     (T.  D.  2090.) 

On  this  point  the  report  to  the  National  Tax  Association  says: 

Individuals  Should  be  Permitted  to  Deduct  Taxes  Paid  within  the 
Year  in  Foreign  Countries  upon  the  Property  or  Business  from 
Which  the  Taxable  Income  was  Derived. 

The  fourth  deduction  allowed  to  corporations  reads  as  follows: 
"(Fourth)   All  sums  paid  by  it  within  the  year  for  taxes  imposed 
under  the  authority  of  the  United  States  or  of  any  state  or  territory 
thereof,  or  imposed  by  the  government  of  any  foreign  country." 

Your  Committee  is  of  opinion  that  individuals  should  be  permitted 
to  deduct  taxes  paid  to  foreign  countries.  No  good  reason  occurs  to 
us  why  the  individual  engaged  in  business  should  be  denied  the  right 
extended  to  corporations. 

In  his  report  of  December  6,  1915,  the  Commissioner  of  Internal 
Revenue  recommended  that  foreign  taxes  be  made  allowable  deductions. 

It  has  been  ruled  that  customs  duties  paid  during  the  year  by  an 
individual  are  allowable  deductions  as  taxes  or  as  part  of  the  cost 
price  if  the  individual  is  engaged  in  the  importation  of  goods  and 
merchandise. 

Tax  Paid  on  "Tax  Free"  Bonds  Deductible 

The  amount  of  taxes  paid  by  a  corporation  in  respect  of  the  "tax 
free"  clause  in  its  bonds  is  not  deductible  by  the  corporation,  but  does 
constitute  an  allowable  deduction  to  the  individual  for  whose  account 
the  tax  is  paid.    The  amount  thereof  to  be  deducted  is  1  per  cent  of  the 


FEDERAL    INCOME    TAX  795 

income  of  this  nature  reported  in  column  A  of  the  return.  When  so 
treated,  the  individual  should  add  to  the  amount  of  interest  the  tax 
paid  in  his  behalf. 

Taxes  Paid  by  Banks  on  Bank  Stock  Held  by  Individuals 

Taxes  assessed  against  the  stockholders  of  a  bank  and  paid  by  the 
bank  in  behalf  of  the  stockholders  do  not  constitute  an  allowable  de- 
duction from  the  gross  income  of  the  bank,  but  do  constitute  an  allow- 
able deduction  in  the  return  of  the  individual.  If  such  individual  is 
subject  to  the  additional  tax  on  dividends,  the  amount  of  taxes  so 
paid  should  be  included  in  his  return  as  income,  the  said  amount  being 
considered  as  an  additional  dividend. 

Income  Tax  as  an  Allowable  Deduction 

For  the  purpose  of  claiming  as  allowable  deductions  the  amounts 
paid  to  the  collector  and  the  amounts  withheld  at  the  source  on  ac- 
count of  the  income  tax,  it  is  held  that  amounts  of  both  classes  are 
paid,  within  the  meaning  of  the  law,  in  the  year  in  which  assessment 
is  made  and  the  tax  paid  to  the  collector  of  internal  revenue. 

Taxes  Assessed  Against  Local  Benefits 

Taxes  paid  pursuant  to  assessments  levied  by  special  districts,  such 
as  irrigation,  reclamation,  drainage  districts,  etc.,  for  sidewalks  in  cities, 
street  extension,  grading,  paving,  etc.,  are  held  to  be  "taxes  assessed 
against  local  benefits."  Such  taxes  are  not  allowable  deductions  in  a 
return  of  annual  net  income.     (T.  D.  2090.) 

Losses 

The  next  item  is  losses.     The  law  permits  the  deduction  of: 

Losses  actually  sustained  during  the  year  incurred  in  trade  or  arising 
from  fires,  storms,  or  shipwreck,  and  not  compensated  by  insurance  or 
otherwise. 

One  of  the  first  rulings  relating  to  losses  was  by  Deputy  Internal 
Revenue  Commissioner  Speer  who  early  in  1914  made  the  following 
ruling : 

Profits  and  Losses  on  Securities  Purchased  Prior  to  March  1,  1913, 
TO  be  Prorated. 

If  securities  were  purchased  prior  to  March  1,  1913,  and  disposed  of 
at  a  profit  or  loss  during  1913,  and  no  annual  adjustment  is  made  on 
the  books,  the  profits  or  loss  as  ascertained  when  sold  (that  is,  the 
difference  between  the  cost  and  the  selling  price),  shall  be  prorated 
and  the  proportionate  profit  or  loss  from  March  1  would  be  gain  or 
allowable  deduction. 


796 


AUDITING 


If  the  stock  was  purchased  after  March  1,  1913,  and  sold  at  a  later 
date,  during  that  year,  the  entire  profit  or  loss  in  the  transaction  would 
be  considered  a  gain  or  an  allowable  deduction  in  computing  the  net 
income. 

This  ruling  was  reasonable  and  equitable  and  being  made  soon  after 
the  passage  of  the  law  would  indicate  a  close  relation  to  what  was  in 
the  minds  of  the  legislators.  Where  there  is  an  ambiguity  in  a  law, 
the  courts  attempt  to  ascertain  the  intention  of  those  who  enacted  it. 

Bearing  directly  on  this  point,  Judge  Hull,  already  referred  to  as 
the  writer  of  the  income  tax  bill,  was  asked  in  the  House  of  Repre- 
sentatives whether  a  person  making  a  profit  on  one  investment  and  a 
loss  on  another  would  be  permitted  to  offset  the  loss  against  the  profit. 
Mr.  Hull  is  quoted  as  saying  in  reply  that : 

If  he  is  simply  making  a  casual  investment  of  that  kind  now  and 
then,  or  here  and  there,  I  think  he  would  report  his  gains  for  taxable 
purposes,  and  probably  would  be  allowed  for  his  loss.  It  would  not 
be  a  trade  loss,  but  set  off  against  the  particular  gain  from  the  other 
stock  transactions.     (Congressional  Record  for  April  26,  1913,  page  10.) 

On  this  question  the  report  to  the  National  Tax  Association  says: 

It  is  immaterial  from  a  practical  point  of  view  whether  the  owner 
of  a  given  business  is  an  individual  or  a  corporation.  The  same 
deductions  should  be  allowed  to  each.  No  reason  has  occurred  to 
the  Committee  why  an  individual  should  be  allowed  to  deduct  losses 
arising  from  fires,  storms,  or  shipwreck  and  not  from  floods  and  other 
calamities.  The  English  law  permits  the  deduction  of  any  loss  con- 
nected with  or  arising  out  of  the  trade.  Whether  or  not  that  rule  be 
adopted,  deductions  for  losses  should  be  uniformly  allowed  to  all  busi- 
ness enterprises,  regardless  of  the  fact  that  the  business  may  be  con- 
ducted by  corporations  or  by  individuals. 

The  law  permits  the  deductions  by  individuals  of  losses  "incurred 
in  trade."  The  Treasury  Department  holds  this  to  mean  losses  incurred 
in  the  business  of  the  taxpayer  and  to  preclude  the  deduction  of  losses 
on  isolated  investments. 

On  the  other  hand,  gains  from  isolated  investments  are  taxed. 

Perhaps  no  provision  of  the  law  has  met  with  more  objection  than 
this.  Your  Committee  urges  that  the  law  be  changed  to  permit  the 
deduction  of  losses  with  respect  to  any  transaction  where  the  gains 
are  taxed. 

Much  argument  could  be  made  on  the  proposition  that  increase  in 
capital  assets  is  not  income  in  the  true  sense  of  the  word,  but  for  the 
purpose  of  the  tax  it  works  substantial  justice  to  tax  gains  on  trans- 
actions involving  exchange  of  capital  assets.  To  be  consistent  and 
just,  however,  the  converse  must  be  recognized  and  losses  should  be 
permitted  to  offset  gains. 

Your  Committee,  therefore,  recommends  that  the  fourth  deduction 
allowed  to  individuals  should  include  all  losses  incurred  in  the  business, 
trade  or  profession  in  which  they  are  engaged  and  all  losses  of  prop- 
erty used  for  investment  or  speculative  purposes  where  the  gain,  if 
any,  would  be  subject  to  tax. 


FEDERAL    INCOME    TAX 


79: 


To  the  lay  mind  the  words  "in  trade"  have  a  broad  meaning  and 
comprehend  all  of  the  transactions  involved  in  the  purchase  and  sale 
of  real  estate,  securities,  etc.,  as  well  as  similar  dealings  in  other 
commodities. 

The  Standard  Dictionary  defines  trade  as: 

1.  A  business  learned  or  carried  on  for  procuring 
subsistence  or  profit. 

2.  Buying  and  selling  for  gain  or  as  a  means  of  live- 
lihood;  mercantile  traffic;  commerce;  hence  any  in- 
dividual bargain. 

The  courts,  too,  seem  to  have  the  same  understanding  of  the  words. 
In  May  v.  Sloan,  101  U.  S.  237,  the  court  said : 

The  word  "trade"  in  its  broadest  signification, 
includes  not  only  the  business  of  exchanging  com- 
modities by  barter,  but  the  business  of  buying  and 
selling  for  money,  or  commerce  and  traffic  generally. 

Black's  Law  Dictionary  defines  trade  as  "the  act  or  business  of 
exchanging  commodities  by  barter ;  or  the  business  of  buying  and  sell- 
ing for  money."  Bouvier's  Law  Dictionary  defines  it  as  "any  sort  of 
dealings  by  way  of  sale  or  exchange,"  and  according  to  the  National 
Reporter  System  it  "means  the  craft  or  business  which  a  person  has 
learned  and  which  he  carries  on  as  a  means  of  livelihood ;  a  purchase 
or  sale ;  a  bargain." 

From  the  foregoing  it  would  appear  to  be  reasonably  certain  that 
when  the  courts  come  to  pass  upon  the  question  it  will  be  decided  that 
if  profits  on  sales  of,  or  dealings  in,  real  estate,  securities,  etc.,  are 
taxable,  then  losses  are  allowable  deductions. 

In  the  meantime  taxpayers  should  take  credit  for  losses  in  their 
returns  and  clearly  specify  the  nature  of  the  items.  No  doubt  the  claim 
will  be  disallowed  and  the  tax  assessed  thereon,  but  the  tax  should 
be  paid  under  protest  and  there  is  at  least  a  reasonable  chance  that 
it  will  be  refunded  some  day. 

In  order  that  the  position  of  the  Treasury  Department  in  regard 
to  allowable  deductions  may  be  understood,  copious  extracts  from  de- 
cisions are  reproduced  here. 

It  will  be  noted  that  the  word  "trade"  is  not  defined,  but  one  syno- 
nym is  taken  and  that  is  defined. 

Several  letters  have  been  received  in  which  inquiry  has  been  made 
as  to  whether  losses  resulting  from  the  sale  of  real  estate  by  individ- 
uals are  properly  deductible  from  gross  income  in  the  returns  of 
annual  net  income  of  individuals  for  the  income  tax. 

Under  paragraph  B  of  the  income  tax  law  it  is  provided  that  among 
the  deductions  to  be  allowed  shall  be: 


798 


AUDITING 


"Losses  actually  sustained  during  the  year,  incurred  in  trade." 

"Losses  actually  sustained  during  the  year,  incurred  in  trade  are 
limited  by  the  language  of  the  act  itself." 

"In  trade,"  is  synonymous  with  business. 

"Business"  has  been  defined  as : 

"That  which  occupies  and  engages  the  time,  attention  and  labor  of 
any  one  for  the  purpose  of  livelihood,  profit,  or  improvement ;  that 
which  is  his  personal  concern  or  interest ;  employment,  regular  occupa- 
tion, but  it  is  not  necessary. that  it  should  be  his  sole  occupation  or 
employment." 

The  doing  of  a  single  act  incidently  or  of  necessity  not  pertaining 
to  the  particular  business  of  the  person  doing  the  same  will  not  be 
considered  engaging  in  or  carrying  on  the  business. 

It  is  therefore  held  that  no  losses  are  deductible  in  a  return  of 
income  save  and  only  those  losses  permitted  and  provided  for  by  the 
statute,  viz.,  those  actually  sustained  during  the  year — Which  are  .  .  . 
"incurred  in  trade."  Or  which  arise  from  .  .  .  "fires,  storms  or  ship- 
wreck, and  not  compensated  for  by  insurance  or  otherwise."  (T.  D. 
1989.) 

"Only  those  losses  are  deductible  which  are  sustained  during  the 
tax  year  'in  trade.'  Loss  to  be  deductible  must  be  an  absolute  loss, 
not  a  speculative  or  fluctuating  valuation  of  continuing  investment,  but 
must  be  an  actual  loss,  actually  sustained  and  ascertained  during  the 
tax  year  for  which  the  deduction  is  sought  to  be  made ;  it  must  be 
incurred  in  trade  and  be  determined  and  ascertained  upon  an  actual,  a 
completed,  a  closed  transaction. 

"The  term  'in  trade,'  as  used  in  the  law  and  in  Treasury  Decision 
2005,  is  held  to  mean  the  trade  or  trades  in  which  the  person  making 
the  return  is  engaged ;  that  is,  in  which  he  has  invested  money  other- 
wise than  for  the  purpose  of  being  employed  in  isolated  transactions, 
and  to  which  he  devotes  at  least  a  part  of  his  time  and  attention.  A 
person  may  engage  in  more  than  one  trade  and  may  deduct  losses 
incurred  in  all  of  them,  provided,  that  in  each  trade  the  above  re- 
quirements are  met.  As  to  losses  on  stocks,  grain,  cotton,  etc.,  if  these 
are  incurred  by  a  person  engaged  in  trade  to  which  the  buying  or 
selling  of  stock,  etc.,  are  incident  as  a  part  of  the  business,  as  by  a 
rnember  of  a  stock,  grain,  or  cotton  exchange,  such  losses  may  be 
deducted.  A  person  can  be  engaged  in  more  than  one  business,  but  it 
must  be  clearly  shown  in  such  cases  that  he  is  actually  a  dealer,  or 
trader,  or  manufacturer,  or  whatever  the  occupation  may  be,  and  is 
actually  engaged  in  one  or  more  lines  of  recognized  businesses  before 
losses  can  be  claimed  with  respect  to  either  or  more  than  one  line  of 
business,  and  his  status  as  such  dealer  must  be  clearly  established." 
(T.  D.  2090.) 

I  regret  that  it  is  impossible  to  change  the  principle  of  the  other 
decision  to  which  you  refer.  The  Act  of  Congress  requires  that  the 
tax  shall  be  paid  "upon  the  entire  net  income  arising  or  accruing  from 
all  sources,"  permitting  the  deduction  of  certain  specified  kinds  of  ex~ 
penses  and  losses,  one  of  which  is  "losses  actually  sustained  during 
the  year,  incurred  in  trade."  I  have  no  authority  to  permit  any  other 
losses  to  be  deducted  than  those  which  Congress  provides  for.  If 
Congress  had  intended  that  all  losses  might  be  deducted,  it  would 
doubtless  have  so  drafted  the  law.  Therefore,  forbidding  the  deduction 
from  income  tax  returns  of  losses  incurred  outside  the  ordinary  course 
of  business,  but   requiring  the  inclusion   of  profits   made  outside  the 


FEDERAL    INCOME    TAX  799 

business,  is  not  the  act  of  the  Treasury  Department,  but  of  Congress. 
(Extract  from  letter  to  S.  C.  Mead,  Secretary  Merchants'  Association 
of  New  York,  signed  by  Secretary  of  the  Treasury  W.  G.  McAdoo 
and  dated  February  27,  1915.) 

The  Secretary  fails  to  produce  any  affirmative  evidence  to  indicate 
that  Congress  actually  defined  "trade"  as  appears  in  the  later  decisions. 
It  looks  as  if  he  arrived  at  a  conclusion  for  revenue-producing  pur- 
poses and  one  not  warranted  from  such  evidence  as  is  available. 

An  individual  member  of  a  partnership  should,  under  this  section, 
claim  a  deduction  for  the  net  loss,  if  any,  borne  by  him  as  his  share  of 
a  partnership  loss  for  the  preceding  calendar  year;  or  if  the  partnership 
fiscal  year  ended  at  some  other  date,  then  his  share  of  the  loss,  if  any, 
for  a  full  year  ended  at  the  regular  fiscal  date. 

Another  remarkable  decision  relates  to  allowable  deductions  by  those 
who  deal  in  real  estate,  securities,  etc.,  and  who  are  permitted  by  the 
Treasury  Department  to  deduct  losses  in  connection  therewith  when 
incurred. 

Losses  on  Securities,  etc. 

As  mentioned  under  reportable  income  (page  777),  it  is  1  physical 
impossibility  for  dealers  in  real  estate,  securities,  etc.,  to  keep  each 
item  or  parcel  separate,  and  common  sense  would  decree  that  such 
dealers  should  be  permitted  to  inventory  their  property  annually  as  is 
done  by  others.  The  Department,  however,  does  not  sanction  the  prac- 
tice. Until  the  question  is  passed  upon  by  the  courts,  it  would  seem 
advisable  to  report  gains  or  losses  under  the  inventory  method,  and, 
if  the  practice  is  objected  to,  seek  the  Department's  aid  for  a  practical 
system  whereby  their  peculiar  bookkeeping  methods  can  be  followed 
and  still  permit  the  dealers  to  remain  in  active  business. 

Where  it  is  feasible,  and  where  partnerships  desire  to  have  their 
books  accord  with  the  regulations  covering  the  fluctuations  in  securities, 
the  following  method  is  suggested  as  one  which  will  permit  the 
ascertainment  and  book  distribution  of  profits  or  losses  on  the  inventory 
or  market  price  method,  and  provide  for  a  later  adjustment  upon  the 
sale  of  the  securities. 

Open  a  ledger  account  entitled  "Security  Fluctuations."  At  the  end 
of  the  fiscal  year  when  the  books  are  closed,  debit  this  account  and 
credit  partners'  special  capital  accounts  with  any  increase  in  market 
prices  above  cost  or  book  values. 

Credit  this  account  and  debit  partners'  special  capital  accounts  with 
any  decreases  in  market  prices  below  cost  or  book  values. 

Ignore  the  entries  in  this  account  in  making  up  income  tax  returns 
of  the  partnership  or  of  the  individual  partners. 

Subsequently   when   securities   are   sold,    become   worthless,   or  are 


8oo  AUDITING 

otherwise  disposed  of,  debit  or  credit  "Security  Fluctuations"  and  part- 
ners' special  capital  accounts,  reversing  the  original  entries.  The  actual 
profit  or  loss  on  each  sale  will,  of  course,  be  reflected  in  turn  in  the 
security  account  itself,  in  the  profit  and  loss  account,  and  in  the  part- 
ners regular  capital  accounts. 
The  ruling  on  this  point  is : 

Shrinkage  in  value  of  securities :  Bonds  and  securities  are  not  sub- 
ject to  wear  and  tear  within  the  meaning  of  the  federal  income  tax 
law,  and  therefore  depreciation  does  not  apply  to  any  shrinkage  in 
their  value.  Shrinkage  in  the  value  of  securities  as  such  does  not 
constitute  a  loss  actually  sustained  within  the  year,  the  amount  of 
which  is  definitely  ascertained.  Therefore,  under  the  rules  of  this 
office  and  consistent  with  the  provision  of  the  law,  a  shrinkage  in  the 
value  of  bonds  or  like  securities  does  not  constitute  an  allowable 
deduction  from  gross  income  either  as  loss  or  depreciation. 

The  fact  that  bonds  and  similar  securities  were  written  off  at  the 
direction  of  the  Comptroller  of  the  Currency  or  the  state  banking 
department  is  not  material.  A  mere  book  entry  does  not  constitute 
either  a  loss  or  gain  for  the  purpose  of  the  income  tax.  The  fact 
that  bonds  were  written  off  does  not  necessarily  imply  ihat  they  are  a 
total  loss,  nor  is  this  act  a  conclusive  proof  that  any  loss  occurred 
during  the  year  for  which  the  return  is  made. 

Losses  of  this  character  are  only  ascertainable  when  the  securities 
mature,  are  disposed  of,  or  canceled. 

Bad  Debts 

The  next  item  of  allowable  deduction  covers:  "Debts  past  due 
which  have  been  actually  ascertained  to  be  worthless  and  which  have 
been  charged  off  within  the  year." 

Debts  arising  from  unpaid  wages,  salaries,  rents,  and  items  of  simi- 
lar taxable  income,  due  and  payable  on  or  after  March  1,  1913,  will 
not  be  allowed  as  general  deductions  under  paragraph  B  of  the  income 
tax  law  unless  the  income  which  they  represent  has  been  included  in  a 
return  of  gross  inco  ne  for  the  year  in  which  the  deduction  as  a  bad 
debt  is  sought  to  be  made,  or  in  a  previous  year;  and  the  debts,  them- 
selves, have  been  actually  ascertained  to  be  worthless  and  charged  off. 

All  debts  representing  amounts  that  became  due  and  payable  prior 
to  March  1,  1913,  and  not  ascertained  to  be  worthless  prior  to  that 
date,  whether  representing  income  or  a  return  of  capital,  are  held  to 
be  allowable  deductions,  under  paragraph  B  of  the  law,  in  a  return  of 
income  for  the  year  in  which  they  are  actually  ascertained  to  be  worth- 
less and  are  charged  off. 

As  most  persons  and  most  corporations  are  honest,  it  would  have 
been  better  to  permit  as  an  allowable  deduction  accrued  losses  as  well 
as  those  finally  ascertained  to  be  worthless  and  charged  off  within  the 
year.  Every  individual  or  corporation  keeping  books  properly,  sets  up 
a  reserve  to  meet  the  losses  which  have  not  fully  materialized,  but 


FEDERAL    INCOME    TAX  8oi 

which,  based  upon  experience,  will  surely  recur.  The  failure  to  do 
so  is  opposed  to  sound  accounting,  and  if  so  reflected  in  a  balance 
sheet,  will  in  some  states  subject  the  person  who  signs  it  to  severe 
penalties,  including  imprisonment,  for  obtaining  credit  upon  a  false 
financial  statement. 

These  laws  are  the  result  of  many  years  of  hard  work  on  the  part 
of  lawyers,  credit  and  business  men,  and  bankers.  United  States  dis- 
trict attorneys  who  prosecute  fraudulent  bankruptcy  cases  have  been 
particularly  interested  in  securing  legislation  of  this  character. 

It  is  true  that  the  returns  may  be  made  out  by  ignoring  the  net 
results  shown  in  the  books ;  that  is,  claim  as  allowable  deductions  only 
debts  charged  off  within  the  year,  and  omit  the  amount  set  up  as  a 
reserve  for  debts  not  yet  charged  off.  Many  concerns,  however,  include 
the  full  amount  of  the  reserve  and  thus  report  as  net  income  the  exact 
amount  as  shown  by  the  books. 

Inspectors  who  discover  this  method  of  reporting,  usually  see  to  it 
that  an  additional  tax  is  assessed  although  in  an  old  business  the  amount 
charged  off  during  a  year  approximates  the  reserve. 

In  a  new  business  it  would  for  one  year  make  some  difference,  but 
never  enough  to  justify  the  government  aligning  itself,  as  is  now  the 
case,  with  those  who  try  to  fool  themselves  by  failing  to  provide  for 
probable  losses  and  expenses. 

The  law  purports  to  tax  net  income  only.  Therefore,  an  allowance 
should  be  claimed  for  accrued  losses,  based  on  actual  experience  and  at 
an  amount  fixed  in  good  faith.  Without  such  provision,  accounts 
cannot  be  properly  stated. 

If  the  Commissioner  of  Internal  Revenue  does  not  allow  the  claim, 
then  a  restatement  may  be  necessary,  based  on  the  accounts  charged 
off  within  the  year. 

Bonds 

It  has  been  pointed  out  that  under  present  rulings  losses  arising 
out  of  the  purchase  and  sale  of  stocks  and  bonds  are  not  allowable 
deductions. 

It  should  be  noted,  however,  that  bonds  are  "debts"  and  if  they  be- 
come worthless  and  can  be  charged  off,  the  cost  thereof  can  be  entered 
under  this  head  as  an  allowable  deduction. 

Stocks  are  not  "debts"  and  credit  cannot  be  claimed  therefor  as 
with  bonds. 

Depreciation 

The  next  deduction  covers  the  "amount  representing  a  reasonable 
allowance  for  the  exhaustion,  wear  and  tear  of  property  arising  out  of 
its  use  or  employment  in  business.    No  deduction  shall  be  made  for  any 


8o2  AUDITING 

amount  of  expense  of  restoring  property  or  making  good  the  exhaustion 
thereof  for  which  a  deduction  is  claimed  elsewhere  in  this  return." 

The  following  quotations  are  from  the  official  regulations,  decisions, 
and  instructions  of  the  Commissioner.  (It  will  be  noted  that  some  of 
the  rulings  refer  specifically  to  corporations,  but  in  all  cases,  the  prin- 
ciples involved  apply  to  individuals  as  well,  which  accounts  for  the 
extended  quotation  at  this  point.) 

The  deduction  for  depreciation  should  be  the  estimated  amount  of 
the  loss,  accrued  during  the  year  to  which  the  return  relates,  in  the 
value  of  the  property  in  respect  of  which  such  deduction  is  claimed, 
that  arises  from  exhaustion,  wear  and  tear,  or  obsolescence  out  of 
the  uses  to  which  the  property  is  put,  and  which  loss  has  not  been 
made  good  by  payments  for  ordinary  maintenance  and  repairs  deducted 
under  the  heading  of  expenses  of  maintenance  and  operation.  This 
estimate  should  be  formed  upon  the  assumed  life  of  the  property,  its 
cost,  and  its  use.  Expenses  paid  in  any  one  year  in  making  good  ex- 
haustion, wear  and  tear,  or  obsolescence  in  respect  of  which  any  de- 
duction for  depreciation  is  claimed  must  not  be  included  in  the  deduc- 
tion for  expense  of  maintenance  and  operation  of  the  property,  but 
must  be  made  out  of  accumulated  allowances,  deducted  for  deprecia- 
tion in  current  and  previous  years. 

The  depreciation  allowance,  to  be  deductible,  must  be,  as  nearly 
as  possible,  the  measure  of  the  loss  due  to  wear  and  tear,  exhaustion 
and  obsolescence,  and  should  be  so  entered  on  the  books  as  to  con- 
stitute a  liability  against  the  assets  of  the  company  (or  individual) 
and  must  be  reflected  in  the  annual  balance  sheet.  The  annual  allow- 
ance deductible  on  this  account. should  be  such  an  amount  as  that  the 
aggregate  of  the  annual  allowances  deducted  during  the  life  of  the 
property,  with  respect  to  which  it  is  claimed,  will  not,  when  the  prop- 
erty is  worn  out,  exhausted,  or  obsolete,  exceed  its  original  cost. 

This  ruling  conforms  to  correct  accounting  practice.  The  chief 
difficulty  in  its  application  has  arisen  under  the  refusal  of  revenue 
inspectors  to  allow,  in  some  cases  for  both  repairs  and  depreciation, 
on  the  ground  that  the  former  included  the  latter. 

It  is  quite  true  that  an  excessive  allowance  would  be  claimed  if 
items  charged  as  repairs  represented  renewals  or  additions.  The  Wis- 
consin law  covers  the  point  very  well  by  providing  that  repairs  and 
depreciation  together  must  not  exceed  the  deterioration  of  the  property. 

If  the  amounts  claimed  in  the  return  accord  with  the  books  of 
account,  there  will  be  few  cases  where  excessive  depreciation  is  claimed, 
or  where  additions  and  renewals  will  be  found  charged  to  repairs. 

Public  accountants  have  been  for  many  years  urging  upon  their 
clients  the  importance  of  ample  allowances  for  depreciation,  and  the 
task  has  not  been  an  easy  one.  The  tendency  is  towards  insufficient 
rather  than  excessive  depreciation  reserves,  which  means  that  from 
most  taxpayers  the  government  will  collect  too  much  rather  than  too 
little. 


I 


FEDERAL    INCOME    TAX  803 

It  is  not  gratifying  to  observe  that  our  federal  authorities,  whose 
tendency  is  paternalistic,  have  in  their  interpretations  of  the  corporation 
excise  and  the  income  tax  laws,  shown  a  disposition  to  favor  methods 
of  accounting  which  are  most  unsafe  and  which  inevitably  lead  to  bank- 
ruptcy. 

For  instance  in  one  case,  a  textile  manufacturer  whose  mill  must 
work  in  double  shifts,  claimed  a  depreciation  of  his  textile  machinery 
at  the  rate  of  less  than  10  per  cent  per  annum.  This  was  equivalent 
to  less  than  5  per  cent  per  annum  based  on  ordinary  working  hours, 
because  where  machinery  receives  no  rest  it  deteriorates  more  rapidly. 
The  inspector  who  examined  the  accounts,  however,  decided  that  the 
rate  was  too  high  and  upon  appeal  to  Washington  the  inspector  was 
sustained.  It  required  a  further  appeal  and  a  special  trip  to  Washington 
to  sustain  the  claim. 

In  plants  where  machinery  is  run  "overtime,"  depreciation  must  have 
special  consideration.  Because  of  its  constant  use,  there  is  little  oppor- 
tunity to  make  proper  repairs  and  supervise  its  condition  and  main- 
tenance. If  a  double  shift  is  used  (and  in  some  cases  there  are  three 
shifts),  the  responsibility  for  the  up-keep  of  the  machinery  is  divided, 
and  with  divided  responsibility  the  machinery  is  sure  to  suffer.  Then, 
too,  in  such  cases,  new  workmen  and  those  on  night  duty  are  not  so 
efficient  as  the  regular  staff,  and  the  machinery  suffers  accordingly.  Of 
course,  much  depends  on  the  class  of  business.  If  intricate  and  delicate 
machinery  is  in  use,  it  will  be  injured  more  than  if  rough  and  heavy 
work  alone  is  involved.  But  in  all  cases  extra  hours  of  work  involve 
higher  rates  of  depreciation  of  machinery  than  will  be  found  necessary 
for  normal  conditions. 

Fortunately  for  those  who  are  inclined  towards  safe  and  sane 
methods,  the  courts  may  be  depended  upon  to  sanction  proper  rates 
of  depreciation,  so  that  individuals  ■  or  corporations  whose  practice  it 
has  been  to  set  aside  adequate  allowances  rnay  continue  to  do  so. 
Without  question  their  position  will  be  sustained  by  the  courts. 

If  in  the  meantime  inspectors  arbitrarily  insist  on  insufficient  al- 
lowances, and  additional  taxes  are  assessed,  the  taxes  will  of  course 
have  to  be  paid,  but  if  paid  under  protest  the  excess  paid  can  be 
recovered  later. 

Depreciation  Must  Appear  on  Books 

The  law  does  not  state  that  depreciation  must  be  provided  for  on 
the  books,  but  the  author  has  no  sympathy  with  anyone  who  is  not 
willing  to  have  his  income  tax  returns  accord  with  his  books ;  there- 
fore the  position  of  the  Treasury  Department  on  this  point,  while 
it  does  not  follow  the  law  and  will  not  be  sustained  by  the  courts,  is 
reasonable  from  the  standpoint  of  correct  accounting. 


8o4  AUDITING 

The  regulations  provide: 

In  the  examination  of  the  books  of  corporations  for  the  purpose 
of  verifying  their  returns  of  annual  net  income,  revenue  agents  and 
examining  officers  have,  in  many  cases,  declined  to  allow  deductions 
on  account  of  depreciation,  simply  and  only  because  the  amounts 
claimed  in  the  returns  on  this  account  were  not  written  off  on  the 
books  of  the  companies.  This  conforms  technically  with  the  rules 
of  this  office,  requiring  all  deductible  items  to  be  evidenced  by  book 
entries. 

However,  the  law  authorizes  corporations  to  deduct  from  gross 
income  "a  reasonable  allowance  for  depreciation,  if  any."  The  law  does 
not  specifically  require  that,  in  order  to  secure  deduction  on  this  account, 
the  amount  claimed  must  be  written  off. 

It  has  nevertheless  been  consistently  held  by  this  office  that  a  de- 
preciation deduction,  in  order  to  be  allowable,  must  be  a  fair  measure 
of  the  loss  sustained  by  reason  of  the  wear  and  tear,  exhaustion,  or 
obsolescence  of  the  property,  and  must  be  so  entered  upon  the  books 
of  the  company  as  to  constitute  a  liability  against  its  assets. 

Such  "reasonable  allowance"  is  to  be  determined  upon  the  basis 
of  the  cost  and  probable  number  of  years  constituting  the  life  of  the 
property  with  respect  to  which  it  is  claimed. 

Because  of  the  fact  that  the  law  does  not  specifically  require 
amounts,  otherwise  deductible,  to  be  written  off,  many  corporations 
included  in  their  deductions  from  gross  income  reasonable  allowances 
for  depreciation  of  which  there  was  no  evidence  on  their  books. 

It  is  not  the  desire  of  this  office  to  deny,  upon  purely  technical 
grounds,  a  deduction  which  the  law  authorizes  and  which  conforms, 
or  may  be  made  to  conform,  to  the  regulations.  Revenue  agents  and 
examining  officers,  in  the  examination  of  the  books  of  a  corporation, 
will,  therefore,  determine  whether  or  not  the  deduction  claimed  in  its  re- 
turn is  a  fair  and  reasonable  measure  of  the  loss  sustained  during 
the  year,  and  if  they  find  that  thfe  amount  claimed  in  a  return  is  such 
fair  and  reasonable  measure  of  the  loss  and  that  it  was  not  written 
off  on  the  books  of  the  company,  they  will  permit  the  corporation  to 
reopen  its  books,  if  it  so  desires,  and  make  such  entries  as  will  con- 
stitute the  amount,  sought  to  be  deducted,  a  liability  against  the  assets 
of  the  company  and  a  charge  against  the  income  of  the  year  for 
which  the  return  is  made.  Sufficient  time  to  make  such  correcting 
entries  should  be  given  the  corporation  before  the  report  of  the  ex- 
amination is  made  to  this  office,  and  any  recommendations  as  to  addi- 
tional taxes  should  be  made  accordingly. 

If  a  corporation  refuses  or  neglects  to  reopen  its  books  and  write 
off  the  depreciation  claimed  in  the  return,  or  a  reasonable  amount 
measuring  the  loss  sustained  on  this  account,  the  amount  claimed  in 
the  return  will  be  disallowed.  The  correcting  entries  for  each  year, 
if  made,  must  be  such  as  would  have  been  made  had  they  been  made 
at  the  time  the  books  were  closed. 

The  foregoing  instructions  do  not  contemplate  that  a  depreciation 
deduction  is  to  be  allowed  in  every  case  simply  because  it  is  written 
off.  If,  upon  examination,  taking  into  account  the  character  of  the 
property  and  the  uses  to  which  it  is  put,  it  appears  that  the  amount 
written  off  and  deducted  in  the  return  is  in  excess  of  a  reasonable 
allowance  within  the  law,  the  excess  should  be  disallowed. 

When  the  amount  claimed  for  depreciation  has  been  written  off  on 


FEDERAL    INCOME    TAX  805 

the  books  of  the  company,  either  prior  or  subsequent  to  the  making 
of  the  return,  it  remains  for  the  revenue  agent  and  the  examining 
officer  to  determine  whether  or  not  this  amount  is  such  as,  within  the 
meaning  of  the  law  and  regulations,  constitutes  an  allowable  deduction, 
and,  if  it  does,  it  should  be  allowed  and  report  made  accordingly. 

Under  the  corporation  excise  tax  law  the  Internal  Revenue  Com- 
missioner ruled  that  depreciation,  to  be  allowed,  must  be  charged  ofif 
as  an  expense  on  one  side  and  credited  directly  to  the  Property 
account  on  the  other.  This  of  course  disregarded  the  practice  of  all 
well-run  concerns.  Later  the  ruling  was  rescinded  and  from  May  9, 
1912,  it  has  been  recognized  that  depreciation  can  be  expressed  on  the 
books  of  account  by  appropriate  reserve  accounts. 

Reserves  for  Depreciation 

The  Internal  Revenue  Bureau,  however,  goes  a  step  further 
and  provides  that  the  reserves  must  be  used  for  the  purposes  for 
which  they  are  created  and  nothing  else.  The  Commissioner  takes 
the  stand  that  it  is  a  "reasonable  requirement  that  the  fund  set  aside 
for  depreciation  should  be  kept  intact."  Of  course,  if  applied  literally 
this  ruling  would  be  absurd.  Assume  that  a  building  is  expected  to 
last  fifty  years  and  2  per  cent  per  annum  is  reserved  for  depreciation. 
It  is  not  the  custom,  nor,  as  is  pointed  out  elsewhere  in  this  book, 
is  it  good  business  to  put  this  2  per  cent  in  a  separate  bank  account 
and  hold  it  there  intact  for  fifty  years.  There  is  no  separate  fund  to 
represent  it  but  it  is  properly  accounted  for  among  the  assets  gen- 
erally. In  a  letter  to  Willard  H.  Lawton,  C.  P.  A.,  who  took  issue 
with  the  ruling,  the  Commissioner  in  effect  said  that  the  depreciation 
"fund"  could  be  diverted  provided  that  the  expenditures  thereof  were 
not  charged  against  the  reserve  for  depreciation. 

As  this  accords  with  general  practice,  it  will  be  noted  that  the  whole 
subject  is  of  academic  interest  only,  but  in  view  of  the  importance 
given  to  it,  the  rulings  are  reproduced  at  length. 

Reserves  for  Depreciation.  Depreciation  set  up  on  the  books  and 
deducted  from  gross  income  cannot  be  used  for  any  purpose  other 
than  making  good  the  loss  sustained  by  reason  of  the  wear  and  tear, 
exhaustion,  or  obsolescence  of  the  property  with  respect  to  which  it 
was  claimed.  If  it  develops  that  an  amount  has  been  reserved  or 
deducted  in  excess  of  the  loss  by  depreciation,  the  excess  shall  be 
restored  to  income  and  so  accounted  for. 

If  any  portion  of  the  depreciation  set  up  is  diverted  to  any  purpose 
other  than  making  good  the  loss  sustained  by  reason  of  depreciation, 
the  income  account  for  the  year  in  which  such  diversion  takes  place 
must  be  correspondingly  increased. 

The  investment  of  depreciation  reserve  funds  in  the  concern's  own 
plant  in  the  way  of  additions  and  extensions  would  appear  to  be 
such  a  diversion. 

Investments  in  additions  and  extensions  are  primarily  capital  in- 


8o6  AUDITING 

vestments  and  the  fact  that  the  corporation  is  investing  its  deprecia- 
tion funds  in  additions  and  betterments  or  improvements  would  seem 
to  indicate  that  the  amounts  set  aside  on  account  of  depreciation  were 
in  excess  of  a  reasonable  allowance  which  the  law  contemplates  a 
corporation  may  deduct  from  its  gross  income,  and  when  it  shall 
appear  that  by  reason  of  the  investing  of  its  depreciation  funds  in 
additions,  betterments,  and  improvements,  it  actually  adds  to  the  value 
of  its  capital  assets,  it  will  be  insisted  upon  that  the  amount  by  which 
the  assets  are  increased  on  this  account  shall  be  returned  as  income 
and  be  subject  to  the  income  tax. 

Mr.  Lawton's  letter,  taking  issue  with  this  ruling,  was  answered 
as  follows: 

The  only  apparent  reason  for  authorizing  a  deduction  on  account 
of  depreciation  is  to  provide  a  fund  out  of  which  the  property  with 
respect  to  which  depreciation  is  claimed  may  be  renewed  or  replaced, 
or  to  restore  to  the  corporation  the  capital  invested  in  such  property, 
when  it  is  worn  out  or  exhausted. 

This  does  not  mean  that  this  fund  shall  be  locked  up  in  a  vault 
or  that  it  cannot  be  used  to  meet  the  ordinary  demands  of  the  busi- 
ness, but  that  it  shall  be  available  at  any  time  to  meet  purposes  for 
which  it  is  set  aside. 

In  order  that  the  return  may  be  checked  at  any  time  with  the 
books,  this  fund  should  be  carried  as  a  separate  and  distinct  account 
as  a  liability  against  the  assets  of  the  company. 

The  investment  of  this  fund  or  any  part  thereof  in  the  concern's 
own  plant  in  the  way  of  additions  or  extensions  would  appear  to  be 
a  diversion  of  the  fund  to  a  purpose  other  than  the  making  good 
depreciation  previously  sustained.  This  may  be  permitted,  however, 
if  the  property  account  is  charged  with  the  amount  of  the  fund  thus 
used,  in  which  case  the  depreciation  account  remains  a  liability  and 
renewals  and  replacements  when  made  are  charged  against  it  rather 
than  against  current  income. 

In  any  event,  the  depreciation  liability  will  be  reflected  in  the 
annual  balance  sheet. 

Rates  of  Depreciation 

As  heretofore  stated,  the  government  will  be  compelled  to  allow 
such  claims  for  depreciation  as  can  be  sustained  as  actual  or  reason- 
able. For  rates  of  depreciation  on  various  classes  of  property,  and 
methods  of  calculating  same,  see  page  401  of  this  book.  So  far  there 
has  been  no  standardization  of  rates  and  obviously  no  standards  can 
be  established. 

Rulings  relating  to  rates  of  depreciation  are  as  follows: 

This  office  is  in  receipt  of  your  letter  of  the  26th  ultimo,  in  which 
you  state  that  a  representative  of  this  Bureau  in  making  an  examina- 
tion of  the  books  of  corporations  located  in  that  district  for  the  pur- 
pose of  verifying  their  returns  of  annual  net  income,  insists  upon  a 
fixed  per  cent  of  depreciation  to  be  deducted  from  gross  income  of 
said  corporations.  The  percentages  insisted  upon,  you  state,  are  5 
per  cent  on  machinery  of  all  kinds,  3  per  cent  on  fixtures,  1  per  cent 
on  buildings,   7^   per  cent   on   horses   and   wagons. 


FEDERAL    INCOME    TAX  807 

In  reply  to  your  inquiry,  you  are  informed  that  this  office  has  fixed 
no  definite  rates  by  which  an  allowable  deduction  on  account  of 
depreciation  in  the  value  of  any  class  of  property  is  to  be  computed. 
The  rule  which  this  office  has  established  and  which  is  being  very 
generally  followed  by  corporations,  contemplates  that  an  allowable 
depreciation  deduction  shall  be  computed  upon  the  basis  of  the  cost 
of  the  property  and  the  number  of  years  constituting  its  life.  The 
life  of  the  property  necessarily  depends  upon  its  character,  the  uses 
to  which  it  is  put  and  the  conditions  under  which  it  is  used.  These 
elements  being  taken  into  consideration,  corporations  should,  as  a 
result  of  experience,  very  closely  approximate  the  number  of  years 
constituting  the  life  of  the  property  and  upon  this  basis  determine 
the  rate  of  depreciation  which  annually  occurs. 

Depreciation  of  Patents 

An  allowance  for  depreciation  of  patents  will  be  made  on  the 
following  basis : 

The  deduction  claimed  for  exhaustion  of  the  capital  assets  as 
represented  by  patents  to  be  made  in  the  return  of  annual  net  income 
of  a  corporation  for  any  given  year  shall  be  one-seventeenth  of  the 
actual  cost  of  such  patents  reduced  to  a  cash  basis.  Where  the 
patent  has  been  secured  from  the  government  by  a  corporation  itself, 
its  cost  would  be  represented  by  the  various  government  fees,  cost 
of  drawings,  experimental  models,  attorney's  fees,  etc.  Where  the 
patent  has  been  purchased  by  the  corporation  for  a  cash  consideration, 
the  amount  would  represent  the  cost.  Where  the  corporation  has 
purchased  a  patent  and  made  payment  therefor  in  stocks  or  other 
securities,  the  actual  cash  value  of  such  stocks  or  other  securities  at 
the  time  of  the  purchase  will  represent  the  cost  of  the  patent  to  the 
corporation. 

With  respect  to  the  depreciation  of  patents,  one-seventeenth  of  the 
cost  is  allowable  as  a  proper  deduction  each  year  until  the  cost  of 
the  patent  has  been  returned  to  the  corporation.  Where  the  value  of  a 
patent  has  disappeared  through  obsolescence  or  any  other  cause  and 
the  fact  has  been  established  that  the  patent  is  valueless,  the  unre- 
turned  cash  investment  remaining  in  the  patent  may  be  claimed  as  a 
total  loss  and  be  deducted  from  gross  income  in  the  return  of  annual 
net  income  for  the  year  during  which  the  facts  as  to  obsolescence 
or  loss  shall  be  established,  such  unreturned  cash  value  to  be  fixed 
in  accordance  with  the  proportion  that  the  number  of  years  which  the 
patent  still  has  to  run  bears  to  the  full  patent  period  of  seventeen 
years. 

Depreciation  of  Good- Will 

"Good-will"  represents  the  value  attached  to  a  business  over  and 
above  the  value  of  the  physical  property,  and  is  such  an  entirely 
intangible  asset  that  no  claim  for  depreciation  in  connection  therewith 
can  be  allowed. 

Depreciation  of  Timber  Lands 

Owners  of  tracts  of  timber  lands,  removing  therefrom  and  selling, 
or  otherwise  disposing  of  the  timber  will  be  permitted  to  deduct  from 


8o8  .  AUDITING 

their  gross  income  on  account  of  depreciation  or  depletion  an  amount 
representing  the  original  cost  of  such  timber,  plus  any  carrying  charges 
that  may  have  been  capitalized  or  not  deducted  from  income.  The 
purpose  of  the  depreciation  or  depletion  deduction  is  to  secure  to  the 
corporation,  when  the  timber  has  been  exhausted,  an  aggregate  amount 
which,  plus  the  salvage  value  of  the  land,  will  equal  the  capital  actually 
invested  in  such  timber  and  land. 

When  an  amount  sufficient  to  return  this  capital  has  been  secured 
through  annual  depreciation  deductions,  no  further  deduction  on  this 
account  shall  be  allowed.  For  the  purpose  of  increasing  the  deduction 
on  this  account  no  arbitrary  increase  in  values  shall  be  made,  unless 
such  increase  in  value  shall  be  returned  as  income  for  the  year  in 
which  the  increase  in  value  was  taken  up  on  the  books. 

Unearned  Increment  as  Affecting  Depreciation 

Unearned  increment  will  not  be  considered  in  fixing  the  value  on 
which  depreciation  shall  be  based. 

Depreciation  of  Theatrical  Costumes 

If  costumes  purchased  by  actors  and  actresses  are  used  exclusively 
in  the  production  of  a  play,  and  are  not  adapted  for  occasional  per- 
sonal use,  and  are  not  so  used,  a  deduction  may  be  claimed  on  account 
of  such  depreciation  in  their  value  as  occurs  during  the  year  on 
account  of  wear  and  tear  arising  from  their  use  in  the  production 
of  the  play,  or  to  their  becoming  obsolete  at  the  close  of  the  production. 

Physicians'  Claims  for  Depreciation 

In  New  York  City  a  physician  made  the  following  claims  for 
depreciation : 

Residence.     Brick  construction.     On  part 

occupied  as  offices  only 5% 

Automobile  20% 

Books  20% 

Instruments 25% 

Office  furniture  20% 

Country  residence.    Wood  construction. .  10% 

Depletion 

The  next  item  of  allowable  deduction  provided  for  is  an  "amount 
allowed  to  cover  depletion,  in  case  of  mines  and  oil  wells,  not  to  ex- 
ceed 5  per  cent  of  the  gross  value  at  the  mine  or  well  of  the  output 
for  the  calendar  year  for  which  this  return  is  rendered." 

The  decisions  and  regulations  relating  to  this  deduction  are  sum- 
marized below.  While  many  of  the  rulings  refer  to  corporations,  they 
also  apply  to  individuals. 

The  depreciation  of  coal,  iron,  oil,  gas,  and  all  other  natural  de- 
posits must  be  based  upon  the  actual  cost  of  the  properties  containing 


FEDERAL    INCOME    TAX  809 

such  deposits.  In  no  case  shall  the  annual  deduction  on  this  account 
exceed  5  per  cent  of  the  gross  value  at  the  mine  (well,  etc.)  of  the 
output  for  the  year  for  which  the  computation  is  made. 

In  addition  to  the  deduction  to  measure  the  loss  due  to  depletion, 
the  corporation  will  be  allowed  the  usual  depreciation  of  its  machinery, 
equipment,  etc.,  such  depreciation  to  be  determined  on  the  basis  of 
the  cost  and  estimated  life  of  the  property  with  respect  to  which  the 
depreciation  is  claimed. 

Corporations  leasing  oil  or  gas  territory  shall  base  their  deple- 
tion deduction  upon  the  cost  of  the  lease,  and  not  upon  the  estimated 
value,  in  place,  of  the  oil  or  gas. 

Corporations  operating  mines  (including  oil  or  gas  wells)  upon  a 
royalty  basis  only  cannot  claim  depreciation  because  of  the  exhaustion 
of  the  deposits. 

Gross  Value  at  Mine 

"Gross  value  at  the  mine,"  is  held  to  mean  the  gross  price  at 
which  the  product  could  be  sold  at  the  mine ;  that  is,  its  actual  bona 
fide  market  value.  The  owners,  however,  may  deduct  depreciation  from 
royalties  received. 

The  term  "gross"  as  applied  to  "value"  contemplates  the  aggre- 
gate value  of  the  product  at  the  mine  determined  upon  the  basis  of 
the  market  conditions  at  the  time  and  place,  and  is  best  defined  as 
the  price  at  which  the  product  sells  or  would  sell  when  delivered  at  the 
mouth  of  the  mine  in  a  marketable  condition.  Five  per  cent  of  the 
value  thus  determined  will  constitute  the  maximum  amount  which  a 
mining  corporation  may  deduct  under  the  federal  income  tax  law 
from  gross  income  on  account  of  depletion  of  natural  deposits.  This 
does  not  contemplate  that  the  full  5  per  cent  of  the  gross  value  will 
be  allowed  if  the  aggregate  amount  calculated  at  a  less  rate  will  equal 
the  cost  in  place  of  such  deposits  or  secure  to  the  corporation  the 
return  of  its  capital  when  the  deposits  have  been  exhausted. 

The  term  "gross  value  at  the  mine,"  as  used  in  paragraphs  B  and  G 
of  section  2  of  the  act  of  October  3,  1913,  prescribing  a  limit  to  the 
amount  which  may  be  deducted  in  the  return  of  individuals  and 
corporations  as  depreciation  in  the  case  of  mines,  is  held  to  mean 
the  market  value  of  ore,  coal,  crude  oil,  and  gas  at  the  mine  or  well, 
where  such  value  is  established  by  actual  sales  at  the  mine  or  well; 
and  in  case  the  market  value  of  the  product  of  the  mine  or  well  is 
established  at  some  place  other  than  at  the  mine  or  well,  or  on  the 
basis  of  the  bullion  or  metallic  value  of  the  ore,  then  the  gross  value 
at  the  mine  is  held  to  be  the  value  of  the  ore,  coal,  oil,  or  gas  sold, 
or  of  the  metal  produced,  less  transportation,  reduction,  and  smelting 
charges. 

If  the  rate  of  5  per  cent  per  annum  shall  return  to  the  corporation 
its  capital  investment  prior  to  the  exhaustion  of  the  deposits,  the 
rate  on  which  the  annual  deduction  for  depletion  of  deposits  is  based 
must  be  lowered  in  accordance  with  the  estimated  number  of  years 
it  will  take  to  exhaust  the  estimated  reserves. 

In  case  the  reserves  shall  be  in  excess  of  the  estimates,  no  further 
deduction  on  account  of  depletion  shall  be  made  when  the  capital 
investment  has  been  returned  to  the  corporation. 

This  limit  will  in  some  cases  be  found  to  restrict  the  exhaustion 


8io  AUDITING 

allowance  to  less  than  the  actual  cost  of  the  minerals  to  the  taxpayers. 
For  instance,  if  a  tract  of  coal  land  costing  $600  per  acre  averages, 
say,  8,000  tons  of  coal  per  acre,  the  cost  of  the  coal  in  place  is  lYz 
cents  per  ton.  The  land  after  being  mined  out  might  have  some  value 
which  would  reduce  the  net  cost  of  the  coal,  but  such  value  is  usually 
comparatively  little  and  for  the  purpose  of  the  present  illustration  may 
be  ignored.  If  the  average  selling  price  per  ton  at  the  mine  during 
the  year  was,  say,  $1.20,  the  maximum  exhaustion  allowance  would 
be  6  cents  per  ton  or  only  80  per  cent  of  the  actual  cost.  Consequently 
the  amount  on  which  the  owner  of  the  mine  would  be  taxed  in  this 
case  would  be  in  excess  of  the  true  income  from  the  mine. 

Exhaustion  of  Oil  Wells.  The  5  per  cent  allowance  must  be  very 
carefully  handled  by  lessors  of  the  land  on  which  the  wells  are  located. 
It  is  customary  in  leasing  oil  lands  for  the  lessor  to  receive  as  royalty 
a  fixed  part  of  the  oil  produced  by  the  wells,  one-eighth  of  the  out- 
put being  a  widely  used  figure.  Assuming  that  the  entire  production 
of  the  wells  (over  the  sale  of  seven-eighths  of  which  the  lessor  has 
no  control)  is  sold  at  about  the  same  average  price  at  which  he  sells 
his  royalty  oil,  5  per  cent  of  the  value  of  the  oil  produced  would  be 
equal  to  40  per  cent  of  the  royalties  received. 

The  cost  of  drilling  dry  holes  (i.e.,  if  oil  is  not  struck)  should  be 
taken  credit  for  as  expenses  of  operation  and  not  as  a  depreciation 
allowance. 

The  report  to  the  National  Tax  Association  says  on  this  point : 

Allowances  for  the  Depreciation  of  Property  and  for  the  Deple- 
tion OF  Natural  Resources  Should  be  on  a  Basis  Which  Will 
Permit  the  Return  of  the  Capital  Invested  Therein,  Free  from 
Tax,  as  Nearly  as  Possible  Coincident  with  the  Obsolescence 
of  the  Property  or  the  Exhaustion  of  the  Resources. 

The  same  rule  should  apply  to  allowances  for  depletion  of  natural 
resources  as  to  depreciation.  That  is,  the  amount  of  capital  originally 
expended  by  the  corporation  or  individual  owner  in  development  work 
should  be  returned  free  from  tax.  The  annual  allowances  should  not 
be  limited  to  5  per  cent  of  the  gross  value  at  the  mine,  but  should 
be  such  reasonable  amount  as  will  in  the  aggregate  equal  the  amount 
of  capital  originally  expended  at  or  as  near  as  possible  to  the  time 
when  the  natural  resources  are  exhausted.  If  the  allowance  aggre- 
gates an  amount  equal  to  the  amount  of  capital  originally  invested 
before  the  resources  are  exhausted,  no  further  allowance  should  be 
made,  as  the  net  income  thereafter  will  represent  gain  entirely.  Should 
the  natural  resources  diminish  more  rapidly  than  estimated,  a  larger 
allowance  should  be  made,  permitting  if  necessary  a  claim  equal  to 
the  entire  net  income  in  the  year  in  which  exhaustion  occurs. 

Your  Committee  would  suggest  the  adoption  of  the  Wisconsin 
phraseology,  which  has  been  found  to  be  both  practicable  and  suffi- 
ciently elastic  to  permit  of  equitable  application.  The  Wisconsin  law 
authorizes  "in  the  case  of  mines  and  quarries  an  allowance  for  deple- 


FEDERAL    INCOME    TAX  8ll 

tion   of  ores  and  other  natural  deposits  on  the  basis   of  their  actual 
original  cost  in  cash  or  the  equivalent  of  cash." 

OVERPAYMENT  OF  TAX 

(Forms  1008  revised  and  46) 

It  frequently  happens  that  by  reason  of  the  tax  having  been  with- 
held at  the  source  on  a  large  amount  of  income,  the  total  deduction 
from  "net  income"  will  be  in  excess  thereof.  Where  the  total  net 
income  is  in  excess  of  $20,000,  there  will  of  course  appear  an  amount 
of  additional  tax  to  be  paid,  and  it  would  seem  to  be  beyond  cri.i- 
cism  and  an  efficient  method  of  settlement  for  the  amount  of  the  tax 
on  the  excess  of  deductions  to  be  deducted  from  the  total  additional 
lax,  thus  making  one  net  amount  to  be  levied  ty  and  paid  to  the  gov- 
ernment. It  has  been  held,  however,  that  the  total  amount  of  addi- 
tional tax  must  be  paid  in  full  and  the  overpayment  to  the  govern- 
ment by  those  deducting  the  tax  at  the  source  must  be  collected  by 
claiming  a  refundment.  If  a  simple  claim  upon  using  the  required 
form  and  presenting  the  proven  evidence  were  sufficient  to  procure  a 
refund  of  the  overpayment,  the  annoyance  might  not  be  burdensome, 
but  unfortunately  when  the  Treasury  of  the  United  States  receives 
money  to  which  it  is  not  entitled  it  is  a  long  and  troublesome  task 
to  get  it  back. 

In  one  case  a  taxpayer  whose  net  income  was  $44,000  and  whose 
total  deductions  were  $52,000,  was  subject  to  an  additional  tax  of 
$240  which  he  was  forced  to  pay.  This  made  an  overpayment  for 
which  he  was  entitled  to  a  rebate  of  $80.  He  was  required  to  execute 
and  file  Form  46,  which  was  done.  After  waiting  a  long  time  he 
received  a  letter  from  the  collector  of  his  district  advising  him  that 
he  had  better  send  in  a  duplicate  of  Form  1040  revised,  as  there  might 
be  difficulty  in  locating  the  original  filed  by  him  in  due  course  seven 
months  previously !  This  was  done,  but  up  to  this  time  the  overpay- 
ment has  not  been  refunded. 

Adjustment  Before  Overpayment  of  Tax 

If  possible,  an  individual  having  an  income  on  which  the  tax  may 
be  withheld  at  the  source  in  an  amount  exceeding  his  total  net  income, 
should  so  arrange  that  an  adjustment  will  be  made  before  the  tax  is 
assessed  and  collected,  thus  obviating  the  painful  delay  and  annoyance 
of  trying  to  get  the  overpayment  refunded.  This  is  accomplished  by 
filling  out  Form  1008  revised. 

The  Commissioner's  regulations  relative  thereto  are  as  follows : 

1,  A  person  who  has  had  income  tax  withheld  from  his  income 
during  the  year   1914  in  excess  of  his  total  liability  for  the  normal 


gl2  AUDITING 

tax  should  file  Form  1008  revised,  with  either  the  withholding  agent, 
or  the  collector  of  internal  revenue  with  whom  the  withholding 
agent's  return  is  required  to  be  filed,  as  he  may  elect.  The  with- 
holding agent  is  required  by  Treasury  Decision  1965  to  retain 
the  amount  of  tax  withheld  by  him  until  thirty  days  prior  to 
March  1,  1915,  in  order  to  refund  amounts  withheld  in  excess  of  the 
taxpayer's  liability  for  the  normal  tax,  should  a  proper  claim  be  filed 
for  deductions  and  exemptions.  He  is  required  by  law  to  file  his 
return  on  or  before  March  1,  1915,  and  may,  in  his  discretion,  file 
his  return  on  any  date  between  January  1  and  March  1.  If  he  has 
filed  his  return  with  the  collector,  Form  1008  revised  should  also  be 
filed  with  the  collector,  who  will  notify  the  withholding  agent  and 
authorize  him  to  make  a  refundment,  changing  the  entry  on  the  re- 
turn and  filing  therewith  Form  1008  revised  as  a  voucher  for  the 
refundment.  If,  however,  the  withholding  agent  has  not  filed  his 
return,  and  a  claim  on*  Form  1008  revised  is  filed  with  him,  he  will 
make  the  proper  refundment  on  his  own  responsibility,  filing  Form 
1008  revised  as  a  voucher  therefor.  If  Form  1008  revised  is  filed 
with  the  collector  under  these  circumstances,  he  will  authorize  the 
withholding  agent  to  make  refundment.  The  withholding  agent  is 
not  required  by  law  to  forward  to  the  collector  the  tax  withheld  by 
him  until  he  has  received  notice  of  assessment  and  then,  like  the  tax 
assessed  in  other  cases,  payment  should  be  made  by  him  on  or  before 
June  30  of  each  year. 

2.  Where  there  are  two  or  more  withholding  agents  whose  collec- 
tion districts  are  the  same.  Form  1008  revised  should  be  filed  with  the 
collector  of  that  district,  and  a  statement  setting  forth  the  names  of 
the  withholding  agents  and  the  amounts  withheld  by  each  should  be 
attached  to  the  form.  The  collector  will  then  notify  the  withholding 
agents  of  the  exact  amount  that  may  be  refunded  by  each. 

3.  Where  excess  deductions  have  been  made  by  two  or  more  with- 
holding agents  in  different  collection  districts,  Form  1008  revised  may 
be  filed  with  either  collector,  as  the  individual  may  elect;  and  there 
should  be  attached  to  the  form  a  complete  statement  setting  forth  the 
names  of  all  withholding  agents,  the  amounts  withheld  by  each,  and 
the  exact  amount  claimed  as  a  refundment  from  each.  The  collector 
with  whom  the  statement  is  filed  will  accept  it  as  a  part  of  Form  1008 
revised  and  as  subject  to  the  penalties  imposed  by  law,  and  will  notify 
the  withholding  agents,  whether  in  his  district  or  other  districts,  to 
make  the  refundment  claimed  from  each. 

4.  It  is  to  be  noted  that  this  ruling  provides  for  the  execution  by 
the  taxpayer  of  only  one  Form  1008  revised,  covering  all  the  general 
deductions  and  exemptions  claimed  by  him  for  the  tax  year. 

PAYMENT  OF  ERRONEOUS  OR  ILLEGAL  TAXES 

In  all  cases  it  must  be  remembered  that  the  tax  levied  by  the  col- 
lectors must  be  paid  even  if  it  is  clearly  in  error.  The  United  States 
Court  has  said  on  this  point: 

Remedy  at  Law.  Congress  has  aflforded  a  complete  and  adequate 
remedy  at  law  open  to  all  persons  aggrieved  by  the  collection  of  an 
erroneous  or  illegal  revenue  tax.  The  taxpayer  must  pay  the  tax, 
and  he  may  then  bring  an  action  to  recover  it    after  appeal. 


FEDERAL    INCOME    TAX  813 

On  this  point  the  report  to  the  National  Tax  Association  says: 

Application  for  Refund  of  Income  Taxes  with  Consequent  Right 
OF  Appeal  from  the  Decision  of  the  Department  Should  be 
Allowed  Not  Only  as  at  Present  Within  Two  Years  from 
Date  of  Payment  of  the  Tax  but  Also,  as  a  Matter  of  Course, 
at  Any  Time,  Without  Limit,  as  an  Offset,  Where  an  Addi- 
tional Tax  for  Any  Year  Is  Claimed  by  the  Government. 

Section  3220  of  the  Revised  Statutes  now  provides  that  the  Com- 
missioner of  Internal  Revenue,  subject  to  regulations  prescribed  by 
the  Secretary  of  the  Treasury,  is  authorized,  on  appeal  made  to  him, 
to  remit,  refund,  and  pay  back  all  taxes  erroneously  or  illegally  as- 
sessed or  collected,  all  penalties  collected  without  authority,  and  all 
taxes  that  appear  to  be  unjustly  assessed  or  excessive  in  amount,  or 
in  any  manner  wrongfully  collected. 

Application  for  refund  must  be  made  within  two  years  after  the 
tax  is  paid.  (Real  Estate  Savings  Bank  v.  The  United  States,  16  Ct. 
Qs.  335;  27  Int.  Rev.  Rec.  153;  104  U.  S.  728;  28  Int.  Rev.  Rec.  27.) 

The  Act  permits  assessment  by  summary  proceedings  upon  the  dis- 
covery of  taxable  income  at  any  time  within  three  years  after  the  due 
date  of  the  return  in  which  such  income  should  have  been  reported. 
It  often  happens  that  the  inspectors  of  the  Bureau  of  Internal  Revenue 
postpone  examination  of  the  books  of  taxpayers  until  after  two  years 
have  elapsed  and  at  that  time  examine  all  returns  which  have  been 
made  since  the  previous  examination.  In  such  event,  when  the  agent 
of  the  government  is  so  examining  the  records  of  the  taxpayers  for 
unreported  income,  the  taxpayer  also  often  finds  instances  which  would 
lawfully  entitle  him  to  refund,  but  is  precluded  from  applying  there- 
for because  of  the  expiration  of  the  two  years'  limit. 

The  appearance  of  the  agent  for  the  government  is  a  natural  oppor- 
tunity for  the  taxpayer  to  re-examine  his  own  records  in  the  light  of 
new  court  decisions  and  new  departmental  rulings.  The  Committee 
believes  it  only  just  that  he  should  at  that  time  be  enabled  to  assert 
his  right  to  refund  of  excessive  taxes  paid  within  a  period  correspond- 
ing to  that  for  which  additional  taxes  may  be  claimed  by  the  govern- 
ment. 

INDIVIDUAL   EXEMPTION 

On  this  point  the  report  to  the  National  Tax  Association  says : 

The  Specific  Exemption  Should  be  Lowered  and  the  Language  of 
Paragraph  "C"  Should  be  Clarified. 

The  tax  is  now  imposed  on  about  one-half  of  1  per  cent  of  the 
population  of  the  country.  It  should  rest  on  a  larger  proportion  of 
the  population. 

The  exemption  of  $3,000  of  income  to  the  individual  citizen  is  un- 
doubtedly too  high ;  and  since  the  government  needs  additional  revenue, 
the  Committee  recommends  that  the  exemption  be  lowered  to  $2,000. 
We  recognize  that  the  circumstances  attending  the  enactment  and 
first  operation  of  the  law  of  1913  may  have  justified  as  high  an  ex- 
emption as  $3,000,  but  we  believe  that  those  circumstances  are  passed. 


8i4  AUDITING 

and  that  it  is  on  every  account  desirable  to  reduce  the  exemption 
to  $2,000. 

When  this  is  done,  the  provision  relating  to  husbands  and  wives 
living  together  and  making  a  joint  return  of  their  incomes  should 
be  changed  so  as  to  do  away  with  the  absurdity  of  the  present  ar- 
rangement by  which  a  husband  and  wife  receive  a  larger  total  exemption 
if  they  live  apart.  If  the  individual  exemption  is  lowered  to  $2,000, 
it  will  be  entirely  practicable  to  grant  to  a  husband  and  wife  living 
together  and  making  a  joint  report  of  their  income  a  total  exemption 
of  $4,000,  which  would  be  the  same  exemption  that  they  would  re- 
ceive if  they  lived  apart  and  made  individual  returns,  each  receiving 
an  exemption  of  $2,000. 

The  language  of  paragraph  C  leaves  to  judicial  construction  the 
questions  whether  or  not  the  specific  exemption  should  be  deducted 
from  net  income  in  assessing  the  additional  tax ;  whether  or  not  it 
may  be  deducted  by  non-resident  aliens  either  in  tolo  or  in  part  ac- 
cording to  the  proportion  of  a  non-resident  alien's  total  income  arising 
in  this  country;  whether  the  aggregate  incomes  of  husband  and  wife 
are  to  be  considered  as  the  income  of  the  family  as  a  unit  or  those 
having  separate  incomes  are  each  entitled  to  a  deduction  of  $3,000, 
and  an  additional  deduction  of  $1,000  when  living  together.  Before 
these  questions  are  finally  settled  it  will  be  necessary  for  the  highest 
court  to  announce  its  opinion.  This  will  take  several  years,  and 
Congress  in  the  meantime  can  and  should  summarily  announce  its 
intent  in  unmistakable  language. 

The  Secretary  of  the  Treasury,  in  his  report  of  December  6,  1915, 
recommended  that  the  present  exemption  be  lowered  to  $2,000  and 
$3,000  respectively. 

INCOME  OF  NON-RESIDENT  ALIENS 

The  law  provides  that  the  tax  shall  be  levied  upon  the  entire  net 
income  from  all  property  owned  and  of  every  business,  etc.,  carried 
on  in  the  United  States  by  persons  residing  elsewhere.  The  specific 
exemption  of  $3,000  or  $4,000  is  not  extended  to  non-resident  aliens. 

The  Attorney-General  has  rendered  opinions  that  interest  upon 
bonds  and  dividends  upon  corporate  stock  are  not  taxable  to  non- 
resident aliens  whether  or  not  the  securities  themselves  are  in  the 
United  States.  The  reason  for  these  opinions  is  that  the  tax  is  levied 
upon  the  income  from  property,  businesses,  etc.,  and  the  decisions  of  the 
courts  hold  that  the  bonds  and  stocks  owned  by  non-resident  aliens 
are  not  property  within  the  United  States,  that  is,  such  property  as 
has  a  legal  situs  therein.  The  practical  application  is  that  the  income 
from  bonds  and  stocks  held  by  non-resident  aliens  is  taxed  or  taxable 
in  their  hands  abroad,  and  it  is  the  feeling  in  the  United  States  that 
to  tax  such  income  here  would  make  investment  in  our  securities  un- 
desirable. 

The  responsible  heads,   agents,   or  representatives   of  non-resident 


FEDERAL    INCOME    TAX  815 

aliens  who  are  in  charge  of  the  property  owned  or  business  carried 
on  within  the  United  States  by  non-resident  aliens  shall  make  full 
and  complete  returns  of  the  income  therefrom  on  Form  1040  revised, 
and  shall  pay  any  and  all  tax,  normal  and  additional,  assessed  upon 
the  said  income  of  such  non-resident  aliens.     (T.  D.  2090.) 

Under  this  decision  it  is  mandatory  that  all  income  other  than  from 
bonds  and  stocks  accruing  to  a  non-resident  alien,  must  be  reported. 
Income  from  real  estate,  for  instance,  is  taxable. 

FIDUCIARIES 

(Form  1041  Revised) 

No  return  need  be  made  on  this  form  unless  some  one  beneficiary's 
interest  subject  to  the  normal  tax  exceeds  $3,000.  In  other  words, 
while  the  net  income  of  a  beneficiary  may  be  in  excess  of  $3,000,  yet  if 
the  income  on  which  the  tax  was  paid  at  the  source  reduces  the  amount 
below  $3,000,  then  no  return  is  required  on  Form  1041. 

The  regulations  bearing  on  this  are  (in  part)  as  follows: 

Annual  Returns  by  Fiduciaries 

Fiduciaries  shall,  on  or  before  March  1  of  each  year,  make  and 
render  a  return  of  the  income  coming  into  their  custody  or  control 
and  management  from  each  trust  or  estate  when  the  annual  interest 
of  any  beneficiary  in  said  trust  or  estate  is  in  excess  of  $3,000.  This 
return  (Form  1041)  must  contain  an  itemized  statement  of  the  gross 
income  and  deductions  claimed. 

This  duty  cannot  be  delegated  to  another  person.  When  the  interest 
of  any  one  beneficiary  exceeds  $3,000  and  a  return  is  required,  the 
name  and  full  address  of  each  beneficiary  and  the  share  of  income  to 
which  entitled,  even  though  it  be  less  than  $3,000,  must  be  shown ;  and 
in  all  cases  where  the  beneficiary's  interest  is  in  excess  ot  $3,000,  the 
fiduciary  is  required  to  withhold  the  normal  tax  unless  exemption  is 
claimed  under  paragraph  C,  and  then  only  on  the  amount  in  excess 
of  the  exemption  so  claimed. 

A  fiduciary  acting  for  a  beneficiary  in  more  than  one  estate  or  trust 
is  required  to  account  for  each  estate  separately,  and  if  the  amount 
of  income  from  no  one  estate  exceeds  $3,000,  no  return  or  withholding 
will  be  required.     (T.  D.  2090.) 

A  fiduciary  acting  in  the  capacity  of  guardian  when  there  is  but  one 
ward  shall  render  his  return  on  Form  1040  revised,  as  agent  of  the 
beneficiary,  and  not  on  Form  1041  revised;  but  where  there  are  two  or 
more  wards  he  shall  render  a  return  on  Form  1041,  and  a  personal 
return  on  Form  1040  for  each  ward.  A  fiduciary  acting  in  the  capacity 
of  trustee,  executor,  or  administrator,  when  there  is  only  one  beneficiary 
and  that  beneficiary  a  non-resident  alien,  shall  render  a  return  on  Form 
1040,  but  when  there  are  two  or  more  beneficiaries  and  those  bene- 
ficiaries are  non-resident  aliens,  he  shall  render  a  return  on  Form  1041, 


8i6  AUDITING 

and  a  personal  return  on  Form  1040  for  each  such  non-resident  alien 
beneficiary. 

Items  Not  Deductible 

Expenses  of  administration  of  an  estate,  such  as  court  costs,  attor- 
neys' fees,  executors'  commissions,  etc.,  are  chargeable  against  the 
corpus  of  the  estate  and  are  not  allowable  deductions  in  a  return  of  a 
fiduciary  on  Form  1041.     (T.  D.  2090.) 

This,  of  course,  applies  to  such  items  as  are  incurred  once  only, 
and  not  to  the  annual  or  continuing  expenses,  which  are  charges  against 
income. 

In  all  cases  it  should  be  definitely  ascertained  by  a  fiduciary  whether, 
under  state  laws,  the  terms  of  a  will  or  by  the  decree  of  a  court,  the 
commissions  in  question  are  deductible  from  the  corpus  of  the  estate 
or  from  the  income  accruing  to  the  beneficiaries  of  the  estate,  and  his 
action  in  the  matter  should  be  guided  entirely  by  the  facts  thus  ascer- 
tained. If  the  commissions  are  properly  deductible  from  the  corpus 
of  the  estate,  they  should  not  be  included  in  the  fiduciary  return  on 
office  Form  1041  revised,  as  allowable  deductions  against  the  interests 
of  the  beneficiaries.  If,  on  the  other  hand,  the  commissions  are  to  be 
deducted  from  the  Income  of  the  estate  distributable  among  the  bene- 
ficiaries, the  amount  should  be  entered  on  Form  1041  revised,  as  a 
legitimate  and  necessary  expense,  properly  deductible  from  the  income 
of  the  estate. 

Return  by  Beneficiary 

In  answer  to  the  following  inquiry: 

Should  a  beneficiary  report  in  his  annual  return  the  amounts  actually 
received  from  the  fiduciary,  or  should  he  account  for  the  amounts 
reported  by  the  fiduciary  as  having  accrued  to  him  in  accordance  with 
revised  Form  1041  ? 

the  Bureau  of  Internal  Revenue  made  the  following  answer : 

.  .  .  The  taxpayer  is  required  to  account  only  for  the  actual  amount 
received  from  the  fiduciary. 

Taxation  of   Undistributed  Income 

The  income  of  trust  estates,  as  any  other  income,  is  subject  to  the 
income  tax.  When  such  income  is  received  annually  by  a  beneficiary 
of  an  estate,  the  fiduciary  will  withhold  the  normal  tax  due  and  subject 
to  withholding  by  him.  Any  part  of  the  annual  income  of  trust 
estates  not  distributed  becomes  an  entity  and.  as  such,  is  liable  for  the 
normal  and  additional  tax,  which  must  be  paid  by  the  fiduciary.  When 
the  beneficiary  is  not  in  esse  and  the  income  of  the  estate  is  retained 
by  the  fiduciary,  such  income  will  be  taxable  to  the  estate  as  for  an 


FEDERAL    INCOME    TAX  817 

individual,  and  the  fiduciary  will  pay  the  tax  both  normal  and  addi- 
tional. When  the  beneficiary  receives  a  part  only  of  the  income  to 
which  he  is  entitled  from  the  estate,  and  the  balance  is  retained  by 
the  fiduciary,  the  normal  tax  will  be  withheld  on  the  income  paid  to 
the  beneficiary,  and  the  amount  of  such  income  retained  by  the  fiduciary 
will  be  treated  as  income  taxable  to  the  estate  for  both  the  normal  and 
additional  tax,  which  tax  will  be  paid  by  the  fiduciary.  When  the 
gross  net  income  not  distributed  and  remaining  in  the  hands  of  a 
fiduciary  is  less  than  $20,000,  the  estate  will  be  listed  as  a  beneficiary, 
and  only  the  normal  income  tax  will  be  assessable  and  such  tax  will 
be  paid  by  the  fiduciary.  When  the  gross  net  income  not  distributed 
and  remaining  in  the  hands  of  a  fiduciary  exceeds  $20,000,  such  income 
is  subject  to  both  the  normal  and  additional  tax,  and  the  estate  will  be 
listed  as  a  beneficiary  and  both  the  normal  and  additional  tax  will  be 
paid  by  the  fiduciary. 

In  all  cases  where  fiduciaries  act  for  minors  or  other  incompetents, 
they  are  held,  for  the  purpose  of  the  income  tax,  to  be  acting  as  the 
agents  of  such  minors  or  other  incompetents,  and  must  pay  all  tax 
(normal  and  additional)  chargeable  on  such  income  in  their  hands, 
as  though  the  persons  for  whom  they  act  were  acting  for  themselves. 
(T.  D.  2231.) 

The  above  decision  superseded  previous  decisions  and  rulings.  Prior 
thereto  the  practice  was  as  follows : 

.  .  .  where,  under  the  express  provisions  of  a  will  or  of  state  laws, 
'certain  income  passes  into  the  corpus  of  an  estate,  to  go.  eventually 
with  the  estate  to  the  persons  entitled  in  remainder,  the  income  tax 
does  not  attach  to,  and  is  not  collectable  from,  the  specified  income  at 
the  time  of  its  receipt  by  the  executor,  whether  or  not  the  remainder- 
men are  determinable. 

The  income  tax  can  be  levied  only  on  such  income  as  is  payable 
to  some  natural  or  artificial  person  subject  to  the  provisions  of  the  law. 

Income  which  is  accumulating  in  the  hands  of  a  trustee  for  account 
and  benefit  of  a  number  of  distributees  may,  it  is  true,  exceed  $20,000 
in  one  year  in  the  aggregate,  but  where  the  number  of  beneficiaries  is 
such  that  the  share  of  each  one  is  less  than  $20,000,  then  it  appears  to 
be  unjust  to  assess  on  them  the  burden  of  a  supertax  without  the  usual 
compensatory  feature  of  the  supertax,  i.e.,  the  receipt  of  a  large  income 
out  of  which  the  tax  can  be  paid. 

OBLIGATIONS     IMPOSED     UPON     CORPORATIONS     BY 
THE  INCOME  TAX  LAW 

There  are  certain  features  of  the  law  and  the  regulations  which 
aflfect  corporations  only.  General  principles,  such  as  apply  to  all  busi- 
ness enterprises  whether  in  corporate  or  individual  form,  have  been 
fully  covered  in  the  preceding  pages.  The  points  now  to  be  considered 
relate  exclusively  to  corporations. 


8i8  AUDITING 

What  Are  Corporations 

Duty  to  Make  Return  Depends  on  Corporate  Existence  Rather  Than 
on  Income.  The  duty  to  make  a  return  depends  upon  corporate  or 
associational  existence  and  not  upon  the  receipt  of  income.  (T.  D.  2090.) 

Limited  Partnerships  Held  to  be  Corporations.  Limited  Partner- 
ships are  held  to  be  corporations  within  the  meaning  of  this  act  and 
these  regulations,  and  in  their  organized  capacity  are  subject  to  the 
income  tax  as  corporations.     (Art.  86,  Reg.  33.) 

Books  Must  Confirm  Figures  Given  in  Annual  Return 

No  particular  system  of  bookkeeping  or  accounting  will  be  re- 
quired by  the  department.  However,  the  business  transacted  by  cor- 
porations must  be  so  recorded  that  each  and  every  item  set  forth  in 
the  return  of  annual  net  income  may  be  readily  verified  by  an  examina- 
tion of  the  books  of  account.     (Art.  182,  Reg.  33.) 

The  books  of  a  corporation  are  assumed  to  reflect  the  facts  as  to 
its  earnings,  income,  etc.  Hence  they  will  be  taken  as  the  best  guide 
in  determining  the  net  income  upon  which  the  tax  imposed  by  this 
act  is  calculated.  Except  as  the  same  may  be  modified  by  the  pro- 
visions of  the  law,  wherein  certain  deductions  are  limited,  the  net 
income  disclosed  by  the  books  and  verified  by  the  annual  balance  sheet, 
or  the  annual  report  to  stockholders,  should  be  the  same  as  that 
returned  for  taxation.     (Art.  183,  Reg.  33.) 

Returns  by  Corporations  Must  Be  Made  on  Specified  Forms 

Under  the  authority  conferred  by  this  act,  forms  of  return  have 
been  prescribed,  in  which  the  various  items  specified  in  the  law  are  to 
be  stated.  Blank  forms  of  this  return  will  be  forwarded  to  collectors 
and  should  be  furnished  to  every  corpora:ion,  not  expressly  exempted, 
on  or  before  January  1  of  each  year,  in  the  case  of  corporations  mak- 
ing their  returns  for  the  calendar  year,  or  on  or  before  the  first  day 
of  the  next  fiscal  year  in  the  case  of  corporations  making  returns  for 
their  fiscal  year.  Failure  on  the  part  of  any  corporation,  joint-stock 
company,  association,  or  insurance  company  liable  to  this  tax  to  re- 
ceive a  prescribed  blank  form  will  not  excuse  it  from  making  the 
return  required  by  law,  or  relieve  it  from  any  penalties  for  failure  to 
make  the  return  in  the  prescribed  time.  Corporations  not  supplied 
with  the  proper  forms  for  making  the  return  should  make  application 
therefor  to  the  collector  of  internal  revenue  in  whose  district  is 
located  its  principal  place  of  business  in  ample  time  to  have  its  return 
prepared,  verified,  and  filed  with  the  collector  on  or  before  the  last 
due  date  as  hereinafter  defined.  Failure  in  this  respect  subjects  it  not 
only  to  50  per  cent  additional  tax,  but  to  the  specific  penalty  imposed 
for  delinquency.  Each  corporation  should  carefully  prepare  its  re- 
turn so  as  to  fully  and  clearly  set  forth  the  data  therein  called  for. 
Imperfect  or  incorrect  returns  will  not  be  accepted  as  meeting  the 
requirements  of  the  law. 

Returns  of  Subsidiary  Corporations 

The  law  requires  that  a  return  shall  be  made  by  every  corporation, 


FEDERAL    INCOME    TAX  819 

notwithstanding  that  it  may  be  entirely  owned  and  operated  by  another 
corporation. 

On  this  point  the  report  to  the  National  Tax  Association  says: 

The  Parent  and  its  Subsidiary  Corporations  Should  be  Recognized 
AS  a  Single  Entity  for  Purposes  of  the  Return  in  Cases  where 
They  Constitute  a  Single  Operating  System  or  where,  in 
Determining  Net  Income  for  Their  Own  Purposes,  No  Recog- 
nition IN  Accounting  is  Made  of  the  Subsidiary  Companies  as 
Distinct  Operating  Units;  and  in  All  Cases  where  All  the 
Stock  of  the  Subsidiary  Company  is  Owned  by  the  Parent  Com- 
pany, A  Consolidation  of  Figures  Should  be  Allowed  in  Appro- 
priate Cases,  Subject  to  the  Approval  of  the  Department. 

At  the  time  of  the  passage  of  the  income  law  there  existed,  and 
still  exists,  a  well-recognized  method  of  doing  business.  Railroad  cor- 
porations were  perhaps  the  first  to  make  use  of  it  where  it  was  neces- 
sary for  legal  reasons  to  form  separate  corporations  in  the  several 
states  in  which  they  desired  to  hold  franchises.  Business  corporations 
use  the  method  for  convenience  of  operation,  to  protect  trade  names, 
to  utilize  good-will  and  established  reputation,  or  for  other  legal  and 
proper  reasons.  The  method  referred  to  is  that  of  doing  business  by 
means  of  several  corporations  usually  controlled  by  one  known  as  the 
parent  or  holding  comp>any  and  all  constituting  parts  or  branches  of  a 
single  business  enterprise.  The  fact  that  this  method  has  been  used 
at  times  in  attempts  to  restrain  trade  or  create  monopoly  does  not  con- 
demn it.  There  can  be  no  doubt  that  the  majority  of  business  enter- 
prises so  conducted  are  law-abiding  and  honest.  To  work  injustice 
upon  all  in  order  to  punish  a  few  is  contrary  to  the  elementary  prin- 
ciples of  law,  and  it  may  be  questioned  whether  it  is  within  the  province 
of  a  taxing  act  to  attempt  to  regulate  or  to  suppress  a  particular  class 
of  taxpayers.  Justice  and  fair  dealing  demand  that  the  burden  of  the 
tax  should  be  equitably  distributed. 

Transactions  often  take  place  between  parent  and  subsidiary  cor- 
porations, such  as  transfers  of  credit,  sometimes  incorrectly  called 
"gifts,"  from  the  parent  company  to  a  subsidiary,  to  offset  losses  in- 
curred by  the  latter.  Such  transfers  of  credit  should  not  be  treated 
as  either  income  of  the  subsidiary  or  expense  of  the  parent  company. 
As  the  law  now  stands,  a  "gift"  is  not  deductible  from  the  net  income 
of  the  parent  company  but  must  be  accounted  for  as  income  by  the 
subsidiary.  The  result  is  a  double  tax  on  the  amount  involved  in  a 
transaction  which  is  nothing  more  or  less  than  a  bookkeeping  entry. 

The  law  should  be  so  framed  as  to  tax  the  parent  and  subsidiary 
companies  on  their  aggregate  gross  income  minus  their  aggregate 
allowable  deductions  and  to  permit  a  combined  return  covering  all  cor- 
porations constituting  a  single  business  enterprise  or  system  where 
no  distinction  is  made  by  the  company  itself  for  accounting  or  financial 
purposes.  This  disposition  of  the  matter  would  follow  the  practice  now 
used  by  public  service  corporations  in  reporting  to  the  Interstate  Com- 
merce Commission.  This  change  would  not  only  be  in  the  interest 
of  fairness  and  equity  but  would  go  far  toward  simplifying  the  opera- 
tion of  the  law,  substituting  one  return  where  several  are  now  filed, 
and  permitting  easier  inspection  of  the  return  by  the  government. 


820  AUDITING 

Corporations  and  Associations  Not  Subject  to  Tax 
The  law  relating  to  exemption  is  as  follows: 

Nothing  in  this  section  G  (a)  shall  apply  to  labor,  agricultural,  or 
horticultural  organizations,  or  to  mutual  savings  banks  not  having  a 
capital  stock  represented  by  shares,  or  to  fraternal  beneficiary  societies, 
orders,  or  associations,  operating  under  the  lodge  system  or  for  the 
exclusive  benefit  of  the  members  of  a  fraternity  itself  operating  under 
the  lodge  system,  and  providing  for  the  payment  of  life,  sick,  accident, 
and  other  benefits  to  the  members  of  such  societies,  orders,  or  associa- 
tions and  dependents  of  such  members,  nor  to  domestic  building 
and  loan  associations,  nor  to  cemetery  companies,  organized  and  oper- 
ated exclusively  for  the  mutual  benefit  of  their  members,  nor  to  any 
corporation  or  association  organized  and  operated  exclusively  for  re- 
ligious, charitable,  scientific,  or  educational  purposes,  no  part  of  the 
net  income  of  which  inures  to  the  benefit  of  any  private  stockholder 
or  individual,  nor  to  business  leagues,  nor  to  chambers  of  commerce  or 
boards  of  trade,  not  organized  for  profit  or  no  part  of  the  net  income 
of  which  inures  to  the  benefit  of  the  private  stockholder  or  individual ; 
nor  to  any  civic  league  or  organization  not  organized  for  profit,  but 
operated  exclusively  for  the  promotion  of  social  welfare ;  Provided^ 
further,  That  there  shall  not  be  taxed  under  this  section  any  income 
derived  from  any  public  utility  or  from  the  exercise  of  any  essential 
governmental  function  accruing  to  any  state,  territory,  or  the  District 
of  Columbia,  or  any  political  subdivision  of  a  state,  territory,  or  the 
District  of  Coliimbia,  nor  any  income  accruing  to  the  government  of 
the  Philippine  Islands  or  Porto  Rico,  or  of  any  political  subdivision  of 
the  Philippine  Islands  or  Porto  Rico;  Provided,  That  whenever  any 
state,  territory,  or  the  District  of  Columbia,  or  any  political  subdivision 
of  a  state  or  territory,  has,  prior  to  the  passage  of  this  act,  entered 
in  good  faith  into  a  contract  with  any  person  or  corporation,  the  object 
and  purpose  of  which  is  to  acquire,  construct,  operate  or  maintain  a 
public  utility,  no  tax  shall  be  levied  under  the  provisions  of  this  Act 
upon  the  income  derived  from  the  operation  of  such  public  utility, 
so  far  as  the  payment  thereof  will  impose  a  loss  or  burden  upon  such 
state,  territory,  or  the  District  of  Columbia,  or  a  political  subdivision 
of  a  state  or  territory ;  but  this  provision  is  not  intended  to  confer 
upon  such  person  or  corporation  any  financial  gain  or  exemption  or  to 
relieve  such  person  or  corporation  from  the  payment  of  a  tax  as  pro- 
vided for  in  this  section  upon  the  part  or  portion  of  the  said  income 
to  which  such  person  or  corporation  shall  be  entitled  under  such  con- 
tract. 

Exemption  Must  Be  Specific 

Treasury  Decision  2152  says  as  to  this: 

Corporations  liable  to  make  returns :  The  tax  imposed  by  the  federal 
income  tax  law  is  not  imposed  only  upon  such  corporations  as  are 
organized  and  operated  for  profit.  Any  corporation,  joint-stock  com- 
pany, or  association,  and  any  insurance  company,  no  matter  how 
created  or  organized  or  what  the  purposes  of  its  organization  may  be, 
unless  it  comes  within  the  class  of  organization  specifically  enumerated 
in  the  act  as  exempt,  will  be  required  to  make  returns  of  annual  net 


FEDERAL    INCOME    TAX  82 1 

income  and  pay  income  tax  upon  the  net  income  which  arises  and 
accrues  to  it  during  the  year. 

A  corporation  is  not  exempt  simply  and  only  because  it  is  primarily 
not  organized  and  operated  for  profit.  If  income  within  the  meaning 
of  the  law  arises  and  accrues  to  a  corporation  which  is  not  organized 
and  operated  for  profit,  such  income  will  be  subject  to  the  tax  imposed 
by  this  act. 

It  is  therefore  held  that  commercial  men's  associations,  farmers* 
mutual  fire  insurance  companies,  and  like  organizations,  come  within 
the  requirements  of  the  law. 

Corporations  not  completely  organized :  Corporations  which  have 
applied  for  and  never  received  charters,  or  corporations  which  have 
received  charters  and  never  perfected  their  organizations,  transacted 
no  business  and  had  no  income  whatever  from  any  source,  may,  upon 
presentation  of  these  facts  to  the  collector  of  internal  revenue,  be  re- 
lieved from  the  necessity  of  making  returns  of  annual  net  income  so 
long  as  they  remain  in  this  unorganized  condition. 

Mutual  Insurance  Companies  Subject  to  Tax 

The  federal  income  tax  law  provides : 

That  mutual  fire  insurance  companies  requiring  their  members  to 
make  premium  deposits  to  provide  for  losses  and  expenses  shall  not 
return  as  income  any  portion  of  the  premium  deposits  returned  to  their 
policyholders  but  shall  return  as  taxable  income  all  income  received  by 
them  from  all  other  sources  plus  such  portion  of  the  premium  deposits 
as  are  retained  by  the  company  for  purposes  other  than  the  payment  of 
losses  and  expenses  and  reinsurance  reserves. 

It  would  appear  from  this  provision  of  the  law  that  all  assessments 
received  by  a  mutual  fire  insurance  company  and  not  returned  to  the 
policyholders,  but  retained  for  purposes  other  than  paying  losses  and 
expenses  incurred  during  the  year  for  which  the  return  is  made  and 
for  such  reinsurance  reserves  as  the  laws  of  the  state  require,  are 
taxable  income. 

Therefore,  if  mutual  fire  insurance  companies  retain  out  of  moneys 
received  on  account  of  assessments  an  amount  in  excess  of  the  losses, 
expenses,  and  reinsurance  reserves  of  any  particular  year,  that  excess, 
plus  amounts  received  from  interest,  dividends,  or  any  other  source, 
will  be  considered  net  income,  upon  which  the  tax  will  be  assessed. 

The  above  quoted  provision  of  the  law  as  construed  by  this  oflfice 
applies  to  all  mutual  fire  insurance  companies,  regardless  of  the  fact 
that  some  of  them  may  not  be  primarily  organized  for  profit. 

Any  organization  which  has  been  held  by  the  Commissioner  of 
Internal  Revenue  to  come  within  the  class  of  organizations  enumerated 
in  paragraph  G  of  the  income  tax  law  is  not  required  to  deduct  and 
withold  the  normal  tax  from  the  amount  of  any  salary  or  interest  paid 
by  it,  and  it  is  subject  to  no  requirements  of  said  law. 

Interest  on  Bonds  of  Exempt  Organizations 

Such  organizations  are  not  only  relieved  from  the  payment  of  an 
income  tax,  but  are- not  required  to  file  a  monthly  or  annual  list  re- 
turn; however,  income  from  bonds  of  such  an  organization  should  be 


822  AUDITING 

accounted  for  by  the  owner  if  the  said  owner  is  a  taxable  person  or 
corporation. 

Clubs  May  Register  as  Exempt  Organizations 

All  clubs  are  not  exempt  from  the  provisions  of  the  income  tax 
law,  even  though  not  operated  for  profit.  A  club  desiring  to  be 
registered  as  an  exempt  organization  should  file  wuth  the  Commis- 
sioner of  Internal  Revenue  a  copy  of  its  charter,  or  an  affidavit  of 
its  principal  officer,  setting  forth  the  nature  of  its  organization,  the 
purpose  for  which  organized,  the  source,  if  any,  from  which  it  de- 
rives income,  and  the  disposition  made  of  such  income  as  is  received 
by  it  for  consideration  and  determination  as  to  whether  or  not  it  comes 
within  the  class  of  organizations  held  to  be  exempt  under  the  pro- 
visions of  paragraph  G  of  the  income  tax  law. 

Social  Clubs 

Clubs  which  are  organized  and  operated  exclusively  for  pleasure, 
recreation,  and  other  non-profitable  purposes,  and  which  have  no  net 
income  inuring  to  the  benefit  of  any  private  stockholder,  individual,  or 
member,  are  exempt  from  the  requirements  of  the  federal  income 
tax  law. 

FISCAL  YEAR 

In  response  to  a  very  general  demand,  the  following  provision  was 
inserted  in  the  law  relative  to  the  period  as  of  which  corporations 
might  report: 

Any  corporation,  joint-stock  company  or  association,  or  insurance 
company,  subject  to  this  tax  may  designate  the  last  day  of  any  month 
in  the  year  as  the  day  of  the  closing  of  its  fiscal  year  and  shall  be  en- 
titled to  have  the  tax  payable  by  it  computed  upon  the  basis  of  the 
net  income  ascertained  as  herein  provided  for  the  year  ending  on  the 
day  so  designated  in  the  year  preceding  the  date  of  assessment  instead 
of  upon  the  basis  of  the  net  income  for  the  calendar  year  preceding 
the  date  of  assessment ;  and  it  shall  give  notice  of  the  day  it  has  thus 
designated  as  the  closing  of  its  fiscal  year  to  the  collector  of  the  district 
in  which  its  principal  business  office  is  located  at  any  time  not  less 
than  thirty  days  prior  to  the  date  upon  which  its  annual  return  shall 
be  filed. 

The  Commissioner  has  held  that  a  fiscal  period  must  alway?  end 
with  the  last  day  of  some  month,  unless  a  corporation  ceases  business 
on  some  other  day. 

Fiscal  Year  of  New  Corporations 

T.  D.  2137  provides  as  to  the  fiscal  year  returns  of  new  corporations : 


■  FEDERAL    INCOME    TAX 


823 


In  the  case  of  new  corporations,  if  they  shall  file  or  shall  have  filed 
within  the  prescribed  time,  a  notice  designating  the  last  day  of  some 
month  as  the  close  of  the  fiscal  year,  such  corporations  will  be  per- 
mitted to  make  their  returns  as  of  the  period  ended  with  the  date 
designated,  provided  the  period  intervening  between  the  date  of  organi- 
zation of  the  corporation  and  the  date  designated  as  the  close  of  its 
fiscal  year  does  not  exceed  twelve  months.  If  such  period  does  exceed 
twelve  months,  the  corporation  will  make  a  return  for  the  portion  of 
the  calendar  year  preceding  the  beginning  of  the  fiscal  year,  which 
return  must  be  filed  on  or  before  the  first  day  of  March  next  follow- 
ing the  calendar  year  of  which  it  is  a  part.  Corporations  partially 
organized  during  the  year  1914  should  file  a  return  for  the  period  ended 
December  31,  1914.  unless  they  shall  have  established  a  fiscal  year  for 
this  purpose,  and  if  they  shall  have  actually  done  no  business  during 
the  period  for  which  the  return  is  made,  that  fact  will  be  set  out  in  a 
notation  on  or  a  rider  attached  to  the  return. 

T.  D.  2090  provides : 

The  statute  provides  that  returns  must  be  made  on  the  basis  of  a 
calendar  year  unless  the  corporation,  etc.,  involved  shall  designate  a 
fiscal  year,  other  than  the  calendar  year,  in  the  manner  provided  by 
the  statute.  When  the  calendar  year  shall  have  passed,  a  return  of 
income  for  the  entire  period  of  such  calendar  year  is  then  due  and 
must  be  made  out  and  filed  with  the  proper  collector  of  internal 
revenue  on  or  before  March  1  then  next  following.  This  is  true  even 
of  corporations  and  institutions  making  return  as  corporations,  except 
that  such  corporations,  etc.,  are  given  the  privilege  of  filing  with  the 
collector  of  internal  revenue  (with  whom  their  return  must  be  filed) 
not  less  than  thirty  days  (more,  but  not  less)  prior  to  March  1  (the 
date  when  the  return  on  the  basis  of  a  calendar  year  is  to  be  filed), 
a  notice,  in  writing,  setting  forth  that  such  corporation,  etc.,  has 
designated  the  last  day  of  some  month  in  the  year  (other  than  the 
last  day  of  December)  as  the  day  of  the  closing  of  its  fiscal  year,  and 
that  from  the  date  so  designated  as  the  close  of  its  fiscal  year  its  books 
have  been  or  will  be  kept  on  the  basis  of  such  designated  fiscal  year. 
When  this  said  notice  is  filed  with  the  collector  of  internal  revenue, 
a  return  must  then  be  made  on  or  before  March  1  for  such  part  of 
the  calendar  year  elapsed  as  is  not  included  in  the  said  designated 
fiscal  year,  and  return  for  the  full  designated  fiscal  year  must  be  made 
and  filed  within  sixty  days  next  succeeding  the  last  day  of  said 
designated  fiscal  year.  This  rule  will  apply  whether  the  designation 
affects  the  future  or  past,  provided  always  that  the  return  of  income 
cannot  cover  more  than  twelve  consecutive  months. 

Example : 

1914  1915 

A  X  B  C  Y  Z 


Jan.  1    June  30   Dec.  31  Mar.  1    June  30   Aug.  29 

AB  is  calendar  year  and  C  is  March  1,  the  time  when  return  on  the 
basis  of  the  calendar  year  must  be  filed.  At  any  time  not  less  than 
thirty  days  prior  to  C  a  corporation  may  file  with  the  collector  with 
whom  its  return  of  income  must  be  filed,  a  notice  in  writing  setting 


824  AUDITING 

forth  that  said  corporation,  etc.,  has  designated  the  last  day  of  some 
month  in  the  year  (other  than  December  31)  as  the  day  of  the  close 
of  its  fiscal  year,  as  June  30,  represented  by  X;  thereafter,  on  March  1, 
a  return  will  be  filed  for  the  period  AX.  XY  represents  the  first 
designated  fiscal  year,  and  for  this  said  fiscal  year  a  return  of  income 
must  be  made  (covering  the  period  XY)  subsequent  to  June  30  and 
on  or  before  August  29;  in  other  words,  the  sixty-day  period  next 
following  the  close  of  the  fiscal  year.  Thereafter  returns  of  income 
will  be  made  and  filed  annually  subsequent  to  June  30,  and  on  or  before 
August  29. 

The  return  for  a  completed  period  must  be  made  independently  of 
any  other  period.  A  corporation  changing  from  the  basis  of  a  calendar 
year  to  a  fiscal  year,  and  because  of  said  change  having  a  part  of  the 
calendar  year,  for  which  return  is  to  be  made,  will  be  required  to 
make  a  separate  return  for  the  fraction  of  the  calendar  year,  and 
another  separate  return  for  the  entire  fiscal  year;  as  June  30  being 
designated  as  the  end  of  the  fiscal  year,  the  part  of  the  calendar  year 
from  January  1  to  June  30  must  be  covered  in  a  return  to  be  made 
on  or  before  March  1,  then  following,  and  on  or  before  sixty  days  next 
following  June  30  (next  after  the  filing  of  return  for  the  fractional 
part  of  a  calendar  year)  a  return  must  be  made  and  filed  for  the 
entire  fiscal  year  of  the  corporation. 

GROSS  INCOME 

The  first  item  of  importance  in  the  corporation  form  (1031  revised) 
is  that  of  gross  income  from  operations.  As  a  matter  of  classifica- 
tion, the  item  is  of  little  importance  in  itself. 

Under  the  heading  of  allowable  "deductions"  in  the  return  will 
be  found : 

Expenses,  general 

Rentals 

Losses 

Depreciation 

Depletion 

Interest 

Taxes 

Some  corporations  would  deduct  one  or  more  of  these  items  be- 
fore arriving  at  an  amount  which  would  be  called  gross  income  from 
operations,  and  others  consider  gross  income  as  an  amount  from 
which  other  deductions  than  those  mentioned  must  be  made  in  order 
to  arrive  at  net  income. 

However,  little  difficulty  has  been  experienced  in  the  use  of  the 
form.  So  long  as  the  item  of  net  income  is  accurate  it  is  not  believed 
that  the  Internal  Revenue  Commissioner  will,  for  instance,  require  a 
re-analysis  of  a  corporation's  books  of  account  in  order  to  state  the 
amount  of  "general  expenses"  where  no  such  account  appears  in 
the  books. 


FEDERAL    INCOME    TAX  825 

Extracts  from  the  rulings  on  this  point  are  as  follows: 

Inventory  of  Materials  and  Merchandise 

In  order  that  certain  classes  of  corporations  may  arrive  at  their 
correct  income,  it  is  necessary  that  an  inventory,  or  its  equivalent,  of 
materials,  supplies  and  merchandise  on  hand  for  use  or  sale  at  the 
close  of  each  calendar  (or  fiscal)  year  shall  be  made  in  order  to 
determine  the  gross  income  or  to  determine  the  expense  of  operation. 

A  physical  inventory  is  at  all  times  preferred,  but  where  a  physical 
inventory  is  impossible  and  an  equivalent  inventory  is  equally  accurate, 
the  latter  will  be  acceptable. 

An  equivalent  inventory  is  an  inventory  of  materials,  supplies,  and 
merchandise  on  hand  taken  from  the  books  of  the  corporation. 

Gross  Income  Embraces  Income  from  All  Sources 

Gross  income  embraces  not  only  the  operating  revenues,  but  also 
income,  gains,  or  profits  from  all  other  sources,  such  as  rentals, 
royalties,  interest,  and  dividends  from  stock  owned  in  other  corpora- 
tions, and  appreciation  in  values  of  assets,  if  taken  up  on  the  books 
of  account  as  gain. 

Proceeds  of  Sale  of  Capital  Stock  Are  Not  Income 

The  amount  received  by  a  corporation  for  the  original  issue  and 
sale  of  its  capital  stock  is  held  to  be  the  capital  of  the  corporation. 
In  cases  where  the  stock,  as  originally  issued,  is  sold  at  a  price  greater 
or  less  than  the  par  value,  neither  the  premium  nor  the  discount  will 
be  taken  into  account  in  determining  the  net  income  of  the  corporation 
for  the  year  in  which  the  stock  is  sold.  This  is  purely  a  capital  trans- 
action and  the  income  is  neither  increased  nor  decreased  by  reason 
of  the  sale,  per  se,  of  the  stock  at  a  price  greater  or  less  than  its  par 
value. 

Dividends  of  Other  Corporations 

Dividends  from  the  net  earnings  or  established  surplus  created  from 
the  net  earnings  of  any  corporation,  joint-stock  company  or  association, 
and  insurance  company,  are  vested  in  the  stockholder  on  the  date  on 
which  such  dividends  are  declared,  whether  distributed  or  not,  and 
regardless  of  the  time  when  the  surplus  or  undivided  profits  from 
which  such  dividends  are  declared  were  earned  and  entered  on  the 
books  of  the  corporation  as  such.  Dividends  so  declared  .  .  .  should 
be  included  in  the  gross  income  of  corporations,  etc.,  regardless  of  the 
amount  of  income. 

For  comments  on  the  latter  part  of  the  foregoing  ruling,  see  page 
787,  et  scq. 

Earnings  or  Dividends  Received  from  Subsidiaries 

Every  corporation,  no  matter  how  closely  related  it  may  be  to  any 
other  corporation,  is  required  to  make  return  of  annual  net  income 
and  to  pay  any  income  tax  thereby  shown  to  be  due. 


826  AUDITING 

Income  from  Tax-Free  Bonds  Returnable 

The  federal  income  tax  law  specifically  provides  that  corporations 
subject  to  the  law  must  return,  for  the  purpose  of  the  tax,  all  income 
which  they  receive  from  every  source,  the  only  exception  being  income 
received  on  account  of  interest  on  the  obligations  of  a  state  or  its 
political  subdivisions  or  the  obligations  of  the  United  States  or  its 
possessions. 

The  act  also  specifically  enumerates  the  items  which  they  may  allow- 
ably deduct  from  the  gross  income  so  returned.  Under  the  provisions 
of  this  act  corporations  must  return  as  income  the  full  amount  of  the 
interest  received  on  bonds,  although  such  bond  may  contain  a  tax-free 
covenant — that  is,  a  covenant  in  which  the  debtor  corporation  agrees 
to  pay  any  tax  assessed  upon  the  bonds  or  income  therefrom — and 
since  there  is  no  specific  provision  in  the  law  for  excluding  or  deducting 
from  gross  income  interest  upon  bonds  of  this  character,  the  receiving 
corporation  cannot  allowably  omit  or  deduct  such  interest  from  its 
gross  income,  and  the  same  will  necessarily  be  reflected  in  the  net 
income  upon  which  the  tax  is  computed. 

Sinking  Fund  Increment  Taxable  Income 

In  cases  wherein  corporations  set  aside  and  place  in  a  sinking 
fund  under  the  control  of  trustees  their  own  bonds  or  the  bonds  of 
other  corporations  which  they  may  own,  it  is  held  that  the  fund  thus 
set  aside  by  the  corporation  is  an  asset  of  the  corporation,  and  any 
increment  to  that  fund  as  a  result  of  investments  made  by  the  trustees 
having  the  same  in  charge  is  income  to  the  corporation  and  should  be 
so  included  and  accounted  for  in  its  returns  of  annual  net  income. 

If  the  trustees  have  invested  the  amount  of  the  sinking  fund  reserve 
or  any  portion  of  it  in  the  bonds  of  the  corporation  and  such  cor- 
poration pays  to  the  trustees  the  interest  on  these  bonds,  such  cor- 
poration will  be  permitted  to  deduct  such  interest  from  its  gross 
income,  provided  the  amount  of  the  interest  thus  paid,  plus  the  interest, 
on  any  other  outstanding  indebtedness  which  it  may  have,  does  not 
exceed  the  limit  fixed  by  the  law,  and  provided  further  that  the  interest 
paid  to  the  trustees,  together  with  all  other  earnings  on  investments 
of  the  sinking  fund  made  by  the  trustees,  is  included  in  the  income 
of  the  corporation. 

Accrual  Basis 

While  the  law  states  that  certain  expenses  may  be  deducted  only 
when  paid  in  cash  during  the  taxable  year,  yet  the  policy  of  the  de- 
partment directs  that  all  income,  whether  collected  or  not,  must  be 
reported. 

The  regulations  provide  that: 

Accounts  or  bills  receivable  of  a  corporation  are  to  be  treated  as 
income  for  the  year  in  which  they  are  created,  that  is  to  say,  in  the 
year  in  which  the  accounts  are  set  up  on  the  books  or  the  bills  receiv- 
able are  accepted. 


FEDERAL    INCOME    TAX  827 

Appreciation  of  Capital  Assets 

In  almost  all  corporations  instances  occur  where  items  of  assets 
are  sold  or  otherwise  disposed  of  at  a  profit  or  loss  as  measured  by 
the  book  value.  In  the  case  of  corporations  where  appreciation  has 
accrued  exclusively  after  January  1,  1909,  no  objection  can  be  made 
to  reporting  the  item  and  paying  the  tax  thereon.  Where  any  part 
of  the  appreciation  can  be  traced  prior  to  January  1,  1909,  then  no 
tax  need  be  paid  on  such  portion.  If  no  accurate  apportionment  can 
be  made  between  the  part  accrued  prior  to  and  the  part  accrued  sub- 
sequent to  January  1,  1909,  then  it  is  equitable  to  prorate  the  gain 
over  the  entire  period.* 

Rulings  on  this  point  are  as  follows: 

Losses  due  to  fluctuations  during  a  taxable  year  in  the  value  of 
capital  assets,  even  though  evidenced  by  book  entries,  do  not  con- 
stitute such  losses  "actually  sustained"  as  within  the  meaning  of  the 
law  may  be  allowably  deducted  from  gross  income.  Losses  are  not 
actually  sustained  until,  as  a  result  of  a  completed,  a  closed  transaction, 
such  losses  have  been  definitely  ascertained  and  the  amount  they  rep- 
resent has  irredeemably  disappeared  from  the  assets  of  the  individual 
or  corporation. 

Likewise  and  conversely  any  appreciation  in  the  value  of  assets  due 
to  appraisal  or  adjustment  and  taken  up  on  the  books  of  the  individual 
corporation  is  held  not  to  be  income  within  the  meaning  of  the  law 
until  such  appreciation,  as  a  result  of  a  completed,  a  closed  transaction, 
has  been  converted  into  cash  or  its  equivalent,  that  is,  has  been  realized 
as  an  addition  to  and  a  part  of  the  tangible  assets  of  the  individual  or 
corporation.  A  book  entry  reflecting  only  an  enhanced  value  of  assets 
during  the  year  evidences  an  increase  in  the  net  worth  of  the  cor- 
poration or  individual  for  that  year,  an  increase  which,  under  adverse 
conditions,  may  disappear  the  next  year.  An  increase  in  value  thus 
evidenced  is  intangible,  unstable  and  is  not  such  income  as  the  federal 
income  tax  law  contemplates  shall  be  returned  for  purposes  of  the  tax. 

Returnable  and  taxable  income  is  that  actually  realized  during  the 
year,  that  is,  that  which  is  evidenced  by  the  receipt  of  cash  or  its 
equivalent.  Until  any  appreciation  taken  up  on  the  books  has  been 
so  realized,  it  will  not  be  required  to  be  returned  as  income.  Hence, 
in  the  preparation  of  returns  and  in  the  examination  of  books  for 
the  purpose  of  verifying  the  same,  mere  book  entries  of  appreciation 
in  the  value  of  capital  assets  will  be  disregarded. 

It  should  be  understood,  however,  that  in  the  event  of  the  sale 
of  the  assets,  the  increase  in  whose  value  has  been  taken  up  on  the 
books,  the  profit  or  income  to  be  returned  as  a  result  of  the  sale  will 
be  determined  upon  the  basis  of  the  difference  between  the  cost  and  the 
selling  price  of  the  assets ;  that  is  to  say,  in  the  case  of  a  sale,  book 
values  will  be  ignored  save  and  except  as  such  book  values  represent 
the  actual  cost  of  the  properties. 

Any  rulings  previously  made  by  this  office  and  in  conflict  with  the 
holdings  hereinbefore  made  are  superseded  by  this  letter,  but  any  re- 


♦For  an  excellent  article  pointing  out  the  fallacy  of  the  prorating  method. 
Journal  of  Accountancy  for  November,  1915,  page  381  et  seq. 


828  AUDITING 

turns,  adjustments,  or  assessments  made  in  accordance  with  previous 
rulings  will  in  no  wise  be  affected  by  the  foregoing  instructions.  (Let- 
ter to  collectors,  August  14,  1914.) 

The  difference  between  the  original  cost  price  of  property  and  its 
increased  fair  market  value  at  the  time  of  the  incidence  of  the  tax 
may  properly  be  added  to  the  original  cost  in  determining  the  amount 
to  be  deducted  on  account  of  depreciation  of  property  or  for  restoration 
of  capital  in  computing  net  income  from  the  sale  of  such  property. 

Lumber  Companies 

A  lumber  company  in  1903  paid  $2,25  per  thousand  feet  for  standing 
merchantable  hard  wood  timber,  $8.00  per  thousand  feet  for  pine 
timber,  and  $2.00  per  acre  for  cut-over  or  stump  land,  at  which  prices 
the  properties  were  carried  on  the  books  of  the  company.  The  prop- 
erties increased  materially  in  value.  In  its  excise  tax  returns  for  the 
years  1909-1912  the  company  deducted  from  the  gross  receipts  from 
timber  and  stump  lands  sold,  an  amount,  for  return  of  capital  assets, 
which  admittedly  was  no  more  than  the  fair  market  value  of  such 
timber  and  stump  land  at  the  time  of  the  incidence  of  the  excise 
tax.  The  government  allowed  the  original  cost  as  a  deduction  but 
assessed  an  additional  tax  on  the  amount  of  the  increase  of  value 
which  the  company  had  deducted.  The  company  paid  under  protest 
and  sued  to  recover.  Judgment  was  entered  in  favor  of  the  plaintiff 
for  the  amount  of  the  taxes  paid  by  it  under  protest.  (Michell 
Brothers  Company,  plaintiff,  v.  E.  J.  Doyle,  collector,  defendant,  U.  S. 
District  Court,  Western  District  of  Michigan,  Southern  District.) 

Income  of  Contracting  Companies 

As  this  office  requires  no  special  system  of  bookkeeping,  neither 
does  it  require  any  specific  method  by  which  the  net  income  to  be 
returned  by  corporations  shall  be  determined. 

In  the  case  of  a  large  contracting  company,  which  has  numerous 
uncompleted  contracts  which  probably,  in  some  cases,  run  for  periods 
of  several  years,  there  does  not  appear  to  be  any  objection  to  such 
corporation  preparing  its  return  in  such  manner  that  its  gross  income 
will  be  arrived  at  on  the  basis  of  completed  work — that  is  to  say,  on 
jobs  which  have  been  finally  completed  and  payments  made  during  the 
year  in  which  the  return  is  made.  If  the  gross  income  is  arrived  at  in 
this  method,  the  deductions  from  gross  income  should  be  limited  to  the 
expenditures  made  on  account  of  such  completed  contracts. 

Contracting  companies  usually  keep  their  books  by  double  entry 
and  report  the  estimated  net  profit  on  unfinished  contracts.  It  would 
require  many  adjustments  to  comply  with  the  above  regulation,  but 
most  contractors  would  save  a  considerable  amount  of  tax  by  com- 
plying therewith,  so  that  consideration  should  be  given  to  the  method 
mentioned. 

Income  from  Real  Estate  Transactions 

Gains  and  profits  resulting  from  a  real  estate  transaction  are  subject 
to  income  tax  in  so  far  as  they  represent  actual  net  income  for  the 


FEDERAL    INCOME    TAX  829 

year  in  which  the  transaction  occurred.  The  amount  of  income  to  be 
returned  for  the  purpose  of  the  income  tax  in  the  case  of  the  sale  of 
capital  assets  is  the  amount  received  upon  the  sale  of  the  property  in 
excess  of  its  original  cost,  provided  both  the  purchase  and  sale  of  the 
property  took  place  since  January  1,  1909.  If  the  property  was  acquired 
prior  to  January  1,  1909,  the  difference  between  the  cost  price  and  the 
selling  price  will  be  considered  income  to  the  corporation,  which  income 
may  be  prorated  according  to  the  number  of  years  the  property  was 
held  prior  to  its  sale,  and  the  amount  thus  apportioned  to  the  years 
subsequent  to  January  1,  1909,  will  be  returned  as  income  for  the  year 
in  which  the  property  was  sold. 

In  determining  the  arpount  of  income  to  be  accounted  for  on  this 
basis,  the  corporation  will  consider  mortgages,  mortgage  notes,  or  any 
other  credits  received  in  payment  of  the  property  as  though  they  were 
cash,  and  if  it  should  occur  that  the  purchaser  of  any  of  the  property 
should  later  default  in  payment  the  corporation  will  be  entitled  to  take 
credit  as  a  loss  for  the  amount  of  loss  actually  sustained  by  reason  of 
the  default. 

In  determining  the  cost  of  the  property  for  the  purpose  of  arriving 
at  the  profit  realized  upon  the  sale,  it  will  be  permissible  for  the  cor- 
poration to  add  to  the  initial  cost  such  carrying  charges  as  interest, 
taxes,  insurance,  etc.,  provided  such  carrying  charges  have  not  been 
deducted  from  net  income  which  the  corporation  may  have  had  and 
returned  for  years  subsequent  to  January  1,  1909,  and  prior  to  the  date 
of  the  sale  of  the  property. 

In  the  Baldwin  Locomotive  case  the  department  endeavored  to 
tax  a  mere  writing  up  of  capital  assets,  but  the  United  States  Circuit 
Court  of  Appeals  of  the  Third  Circuit  decided  otherwise.  In  the 
opinion  the  court  said: 

When  the  corporation  was  organized  it  took  over  certain  real  estate, 
manufacturing  plant,  and  securities  at  a  valuation,  and  took  over 
also  a  large  amount  of  patterns,  drawings,  tools,  and  fixtures  without 
valuing  them  at  all.  In  1910  the  assets  were  appraised  at  their  actual 
value  as  of  December  31,  1909,  and  by  this  appraisement  the  valuation 
of  certain  shares  of  stock  of  the  Standard  Steel  Works  Co.  was  in- 
creased $485,000;  the  value  of  the  patterns,  drawings,  etc.,  was  fixed 
for  the  first  time  at  $2,954,086.72;  and  the  valuation  of  its  real  estate 
was  adjusted — raised  in  part  and  lowered  in  part — the  net  result  being 
an  increase  of  $593,499.66.  Against  this  total  an  item  not  in  dispute 
was  charged  off,  leaving  as  the  balance  to  be  added  to  the  capital  valua- 
tions 00  its  books  the  sum  of  $3,795,461.25.  On  this  sum  the  govern- 
ment collected  a  tax  of  $37,954.61,  and  this  is  the  second  item  in 
dispute. 

We  agree  with  the  District  Court  that  this  increase  of  valuation 
was  not  income  within  the  meaning  of  the  statute.  Nothing  whatever 
was  added  to  the  corporate  property,  which  remained  exactly  the  same 
after  the  appraisement  as  before.  The  only  thing  done  was  to  put 
upon  the  company's  books  an  expression  of  expert  opinion  that  certain 
property  was  worth  a  certain  sum,  and  this  can  hardly  be  said  to  be 
income,  or  even  gain,  in  any  proper  sense.  The  company  could  not 
become  either  richer  or  poorer  by  making  a  few  book  entries  that 
merely  recorded  a  new  estimate  of  how  much  it  was  worth. 


830 


AUDITING 


Gifts  to  Corporations  Taxable 

The  Treasury  decision  on  this  point  is  as  follows: 

Gifts  to  Corporations  Are  Income.  The  value  or  amount  of  a  gift 
to  a  corporation  is  held  to  be  income  to  such  corporation  and  should 
be  returned  as  such  for  the  year  in  which  the  gift  is  received.  The 
provision  of  the  act  of  October  3,  1913,  which  exempts  gifts,  bequests, 
etc.,  from  the  tax  imposed  by  the  act  applies  to  individuals  and  not  to 
corporations. 

As  a  rule  gifts  are  not  made  to  profitable  corporations.  They  are 
frequently  made  to  unprofitable  ones.  In  the  latter  case  it  would 
seem  that  the  losses  sustained  would  be  large  enough  to  offset  the 
inclusion  of  gifts  as  income.  If  this  is  not  the  case,  the  following 
decision  represents  the  position  of  the  department: 

A  company  which  has  been  unable  to  pay  any  interest  on  its  bonded 
indebtedness  for  some  years  proposes  to  settle  that  indebtedness,  part 
in  new  securities  and  part  in  cash,  the  creditors  to  reduce  the  face 
of  the  bonds  by  $100,000  as  an  inducement  for  the  raising  of  $100,000 
cash. 

By  this  process  the  apparent  financial  condition  of  the  debtor  com- 
pany is  improved  by  $100,000  not  through  any  earnings,  but  by  effect- 
ing a  settlement  with  its  creditors  by  which  $200,000  of  its  bonds  are 
canceled  at  a  cost  to  it  of  $100,000  in  cash,  namely  at  50  cents  on  the 
dollar. 

In  reply  to  your  inquiry  as  to  whether  such  a  compromise  of  in- 
debtedness is  taxable  as  income,  you  are  informed  that  while  in  fact 
the  earnings  of  the  corporation  are  in  no  wise  increased  by  this  com- 
promise, the  liabilities  are  reduced  and  to  that  extent  the  corporation 
gains  in  its  net  worth. 

In  somewhat  similar  cases  to  this,  in  which  the  creditor  has  for- 
given the  debt  of  the  debtor,  this  office  has  held  that  the  amount  of 
the  debt  forgiven,  constitutes  income.  In  this  particular  case,  in  the 
opinion  of  this  office,  the  difference  between  the  amount  realized  by 
the  corporation  when  the  bonds  were  sold  and  the  amount  which  it 
now  is  required  to  pay  upon  the  redemption  of  the  same,  constitutes 
income,  which  income  may  be  prorated  over  the  period  elapsing  be- 
tween the  date  of  the  bond  issue  and  the  date  of  their  payment,  and 
that  portion  of  such  income  apportioned  to  the  years  subsequent  to 
January  1,  1909,  will  be  returned  as  taxable  income  for  the  year  in 
which  the  bonds  are  redeemed. 

Gross  Income  from  Dividends 

That  part  of  the  law  which  relates  to  individuals  provides  among 
the  allowable  deductions  (as  it  affects  the  normal  tax)  :  "The  amount 
received  as  dividends  upon  the  stock  or  from  the  net  earnings  of  any 
corporation,  joint-stock  company,  association,  or  insurance  company, 
which  is  taxable  upon  its  net  income  as  hereinafter  provided";  but  no 
such  provision  is  included  as  relating  to  corporations.  This  is  made 
specific  in  T.  D.  2137; 


FEDERAL    INCOME    TAX  83 1 

The  federal  income  tax  law  specifically  sets  out  that  there  shall  be 
returned  as  gross  income  all  income  received  from  all  sources  during 
the  year  for  which  the  return  is  made,  and  it  specifically  enumerates 
the  items  which  may  be  allowably  deducted  from  such  gross  income. 
There  is  no  provision  of  the  law  whereby  dividends  received  from 
other  corporations  may  be  excluded  from  gross  income  or  deducted 
therefrom.  Each  corporation  is  a  separate  and  distinct  entity  and  must 
return,  for  the  purposes  of  the  tax.  the  income  which  it  receives  (ex- 
cept interest  on  obligations  of  a  state  or  its  political  subdivisions  or 
on  the  obligations  of  the  United  States  or  its  possessions),  regardless 
of  the  source  from  which  such  income  is  received  or  regardless  of 
the  fact  that  a  portion  of  such  income  may  constitute  dividends  from 
other  corporations  subject  to  tax. 

The  intent  of  this  provision  is  obvious  in  that  a  penalty  is  laid  upon 
so-called  holding  corporations.  For  some  inscrutable  reason  the  law- 
makers decided  that  moral  turpitude  was  involved  in  one  corporation 
holding  stock  in  another,  irrespective  of  the  object  intended  or  result 
reached,  so  in  order  to  prevent,  or  lacking  prevention,  to  punish  such 
offenders  it  is  provided  that  a  double  tax  shall  be  paid  on  the  income 
represented  by  dividends  paid  by  one  corporation  to  another. 

The  double  taxation  lies  in  the  fact  that  the  corporation  paying  the 
dividend  is  taxed  1  per  cent  upon  its  entire  net  profits  out  of  which 
dividends  are  paid  and  the  receiving  corporation  is  taxed  again  upon 
its  entire  net  income,  including  such  dividends.  On  this  point  the 
report  to  the  National  Tax  Association  says: 

Every  Corporation  Should  be  Permitted  to  Deduct  All  Amounts 
Received  by  It  Within  the  Year  as  Dividends  upon  the  Stock  of 
Other  Corporations,  Joint-Stock  Companies,  or  Associations, 
Subject  to  the  Income  Tax. 

That  provision  of  the  law  which  taxes  corporations  upon  dividends 
received  from  other  corporations,  while  exempting  such  dividend  in 
the  hands  of  individuals,  is  an  unjust  discrimination  between  classes 
of  taxpayers  and  is  double  taxation  of  income. 

It  seems  to  have  been  the  deliberate  intent  of  Congress  to  tax 
holding  companies  at  a  greater  rate  than  other  taxpayers.  This  is 
accomplished  by  requiring  corporations  to  pay  the  tax  on  dividends 
received  from  other  corporations.  To  penalize  a  corporation  for  hold- 
ing stock  in  other  corporations  under  lawful  authority  of  the  state  in 
which  it  is  incorporated  is  not  within  the  proper  scope  of  a  taxing  act. 
The  ulterior  motive  is  to  be  condemned.  If  Congress  intends  to  dis- 
courage the  holding  of  stock  by  certain  corporations,  suitable  legis- 
lation to  accomplish  that  purpose  should  be  enacted  after  a  full  dis- 
cussion of  the  questions  of  constitutionality  and  public  policy  involved 
therein. 

ALLOWABLE   DEDUCTIONS  TO   CORPORATIONS 
Expenses 

The  allowable  deductions  which  can  be  claimed  by  corporations  cor- 
respond closely  to  those  applicable  to  individuals.    Where  they  are  the 


8:»2  AUDITING 

same,  the  regulations  relative  thereto  and  comments  thereon  will  be 
found  on  pages  789-811,  supra. 

Only  those  points  wherein  the  procedure  differs  from  individuals 
will  be  dealt  with  in  the  following  pages. 

Corporate  deductions  for  expenses  of  all  kinds  may  be  calculated 
on  the  "accrued"  basis,  that  is,  whether  paid  or  not  within  the  tax 
year.    The  regulations  cover  this  as  follows : 

It  is  immaterial  whether  the  deductions,  except  for  taxes  and 
losses,  are  evidenced  by  actual  disbursements  in  cash,  or  whether  evi- 
denced in  such  other  way  as  to  be  properly  acknowledged  by  the 
corporate  officers  and  so  entered  on  the  books  of  the  corporation  as 
to  constitute  a  liability  against  the  asset  of  the  corporation  making 
the  return.  .  .  .  Except  as  the  same  may  be  modified  by  the  provisions 
of  the  act,  limiting  certain  deductions  and  authorizing  others,  the  net 
income  as  returned  for  the  purpose  of  the  tax  should  be  the  same  as 
that  shown  by  the  books  or  the  annual  balance  sheet. 

Accounts  payable,  representing  ordinary  and  necessary  expenses  of 
maintaining  and  operating  the  business  and  property  of  a  corporation, 
if  actually  charged  into  the  Expense  account  and  so  entered  on  the 
books  as  to  constitute  a  liability  against  the  assets  of  the  company,  and 
so  treated  in  the  preparation  of  the  return  of  annual  net  income  that 
they  will  not  be  included  in  the  deduction  in  the  year  in  which  they 
are  actually  paid  in  cash  or  its  equivalent,  such'  accounts  payable  may 
be  deducted  from  the  gross  income  of  the  year  in  which  the  expenses 
were  incurred. 

This  ruling  applies  only  to  accounts  payable  representing  ordinary 
and  necessary  expenses  of  maintaining  and  operating  the  business,  that 
is,  to  such  expenses  as  are  incurred  by  the  corporation  in  producing 
the  gross  income  which  it  is  required  to  return. 

Organization  and  Similar  Expenses 

On  page  345  hereof  will  be  found  the  author's  views  as  to  when  and 
how  incorporation  and  similar  expenses  should  be  charged  off.  If  the 
expenses  are  actual  and  are  incurred  in  good  faith,  they  constitute 
allowable  deductions  for  the  period  during  which  they  appear  on  the 
books  as  charged  to  profit  and  loss. 

The  action  of  certain  inspectors  in  disallowing  deductions  of  this 
nature  is  not  supported  by  the  letter  nor  the  spirit  of  the  law,  and  is 
not  in  harmony  with  official  decisions. 

Proceeds  of  Life  Insurance  in  Favor  of  Corporations 

In  cases  wherein  corporations  pay  premiums  on  insurance  policies 
insuring,  in  favor  of  the  corporations,  the  lives  of  officers  or  others, 
such  premiums  may  be  allowably  deducted  from  the  gross  income  of 
the  corporations  paying  the  same. 

In  all  such  cases,  the  proceeds  of  the  policies  when  paid  at  maturity 
or  upon  death  of  the  insured  shall  be  returned  by  the  corporation  as 
income  for  the  year  in  which  such  proceeds  were  received.  (T,  D.  2090.) 


FEDERAL    INCOME    TAX  833 

Incidental  Repairs 

Incidental  repairs  which  neither  add  to  the  value  of  the  property 
nor  appreciably  prolong  its  life,  but  keep  it  in  an  operating  condition, 
may  be  deducted  as  expenses. 

Improvements 

The  following  extract  from  a  decision  of  the  United  States  Court  is 
of  interest: 

Amounts  expended  by  a  business  corporation  in  enlarging  or  making 
improvements  in  its  office  or  premises,  not  in  the  nature  of  permanent 
improvements  to  the  property,  but  to  facilitate  the  transaction  of  a 
growing  business,  should  properly  be  deducted  as  necessary  expenses 
of  the  business,  (Connecticut  Mutual  Life  Insurance  Co.  v.  Eaton, 
218  F.  206.) 

Pensions  to  Ex-Employees 

Amounts  paid  for  pensions  to  retired  employees,  or  to  their  families, 
or  others  dependent  upon  them,  or  on  account  of  injuries  received  by 
employees,  are  proper  deductions  as  ordinary  and  necessary  expenses. 

Lobbying  Expenses 

Sums  of  money  expended  for  lobbying  purposes  and  contributions 
for  campaign  expenses  are  held  not  to  be  an  ordinary  and  necessary 
expense  in  the  operation  and  maintenance  of  the  business  of  a  cor- 
poration, and  are  therefore  not  deductible  from  gross  income  in  arriv- 
ing at  the  net  income  upon  which  the  income  tax  is  computed. 

Cost  of  Manufactured  Products 

A  manufacturing  corporation  may  include  as  an  element  of  the 
cost  of  manufactured  products,  the  cost  of  the  raw  material,  the  cost 
of  labor  of  the  men  who  actually  work  on  such  products,  as  well  as 
the  cost  of  supervisory,  or  what  may  be  denominated  as  "unproductive" 
labor,  such  as  that  of  the  foremen,  inspectors,  overseers,  etc.,  provided 
such  expenditures  are  not  separately  deducted  from  gross  income  in 
the  return  of  annual  net  income. 

The  overhead  charges  referred  to  in  Form  1031  (revised)  should 
include  the  salaries  of  officers,  clerk  hire,  and  such  other  office  ex- 
penses as  do  not  have  to  do  directly  with  the  manufacture  of  the 
product. 

Items  Entering  Into  Cost  of  Manufacture 

The  only  interest  which  constitutes  an  allowable  deduction  from 
gross  income  under  the  federal  income  tax  law  is  the  amount  actually 
paid  within  the  year  on  the  maximum  principal  ascertained  by  adding 
to  the  full  amount  of  the  paid-up  capital  stock  outstanding  at  the 
close  of  the  year  one-half  of  the  interest-bearing  indebtedness  also 
then  outstanding  and  such  interest  as  is  actually  paid  on  indebtedness 
wholly  secured  by  collateral  the  subject  of  sale  in  the  ordinary  busi- 
ness of  the  corporation. 


B34 


AUDITING 


Interest  payments  of  this  character,  being  allowable  deductions 
from  gross  income,  will  not  be  taken  into  account  as  a  part  of  the 
cost  of  manufacture  for  the  reason  that  to  consider  them  an  element 
of  the  cost  of  manufacture  and  to  deduct  them  from  gross  income  as 
specific  items  would  in  effect  result  in  a  double  deduction  of  amounts 
involved. 

A  corporation  would  not  be  permitted  to  include  in  its  deductions 
the  rental  value  of  the  property  which  it  owns  and  occupies  nor  would 
it  be  permitted  to  deduct  from  gross  income  the  interest  which  the 
capital  invested  or  employed  would  earn  were  it  otherwise  invested. 

It  therefore  follows  that  a  corporation  cannot  take  into  account 
as  a  part  of  the  cost  of  manufacture  any  possible  earnings ;  that  is, 
earnings  which  might  accrue  on  its  capital  or  investment  had  such 
capital  been  so  placed  as  to  earn  a  given  rate  of  interest. 

Gifts,  Gratuities,  or  Bonuses  to  Employees 

Gifts  or  gratuities  to  employees  in  the  service  of  a  corporation  are 
not  properl]^  deductible  in  ascertaining  net  income. 

Gratuities  are  not  allowable  deductions  in  a  return  of  income  by 
corporations.     (T.  D.  2090.) 

In  answer  to  an  inquiry  on  this  point  the  Commissioner  wrote : 

This  office  is  in  receipt  of  your  letter  of  the  19th  instant,  in  which 
you  ask  a  ruling  of  this  office  as  to  how  payments  made  under  the 
bonus  system  or  profit-sharing  plan  may  be  treated  by  corporations  in 
making  their  returns  of  annual  net  income.  .  .  . 

This  office  has  consistently  held  and  still  holds  that  in  cases  where 
these  increased  compensations,  denominated  as  bonuses  or  profit  shar- 
ings,  are  paid  to  the  employees  pursuant  to  a  contract  between  the 
employees  and  the  corporation,  the  amounts  so  paid  will  be  considered 
an  ordinary  and  necessary  expense  of  operation  of  business,  and  as 
such  will  constitute  an  allowable  deduction  from  gross  income  of  the 
corporation  making  such  payments. 

If,  however,  there  is  no  contractual  relation  between  the  employee 
and  the  employer  by  reason  of  which  the  employee  could  enforce  his 
claim  for  the  additional  compensation,  it  is  held  that  these  payments 
are  gratuities  on  the  part  of  the  corporation  and  as  such  are  not 
allowable  deductions  from  gross  income. 

Salaries 

Rulings  relating  to  salaries  and  special  compensation  of  officers  and 
employees  are  as  follows : 

In  regard  to  salaries,  it  has  been  the  consistent  ruling  of  this  office 
that  such  amounts  as  corporations  actually  pay  as  fair  and  reasonable 
compensation  for  the  services  rendered  by  the  officers  or  employees, 
constitute  allowable  deductions  from  gross  income.  The  salaries  such 
as  are  here  defined  should  not  depend  upon  the  profits  earned  by  the 
corporation,  the  presumption  being  that  the  officers  and  employees  of 
corporations  render  services  equally  valuable  regardless  of  the  fact 
that  the  net  earnings  of  the  corporation  may  differ  from  year  to  year. 


FEDERAL    INCOME    TAX  835 

Special  Compensation  When  Deductible 

Special  payments  made  by  a  corporation  as  extra  compensation  to 
certain  of  its  employees  may  be  deducted  from  gross  income,  if  it  is 
clearly  shown  that  such  payments  are  made  as  compensation  for 
services  rendered  and  are  paid  in  pursuance  of  a  contract  expressed 
or  implied. 

If  such  so-called  "compensation"  is  a  gratuity  or  voluntary  pay- 
ment, for  which  no  service  is  rendered,  the  amounts  so  paid  are  not 
deductible.  In  cases  wherein  the  payments  are  made  as  compensation 
for  services  rendered,  the  employee  receiving  the  same,  if  he  be  a 
"taxable  person,"  will  be  required  to  include  the  amount  of  such 
compensation  in  his  personal  income  tax  return. 

Commissions  to  Salesmen  Paid  in  Stock 

Commissions  allowed  salesmen,  paid  in  stock,  may  be  deducted 
as  expense  if  so  charged  on  books  at  the  actual  value  of  such  stock. 

Donations  by  Agricultural  Corporations  to  Fairs,  etc. 

A  corporation  engaged  in  agricultural  business  cannot  be  allowed 
to  make  a  deduction  from  gross  income  on  account  of  donations  to 
fairs,  churches,  and  associations,  such  donations  being  made  for  the 
purpose  of  obtaining  and  preserving  the  good-will  of  the  farmers  who 
raise  crops  for  it,  since  the  amounts  so  expended  are  clearly  in  the 
nature  of  gratuities  and  are  not  necessary  expenses  of  operation  and 
maintenance  as  there  is  no  such  consideration  in  this  case  as  is  con- 
templated in  T.  D.  2090. 

If  followed  literally,  this  decision  would  deprive  some  corporations 
of  the  right  to  claim  advertising  as  an  allowable  deduction.  Many  pub- 
lic service  corporations  advertise  to  retain  the  good  will  of  their  cus- 
tomers, rather  than  to  seek  new  business. 

Fortunately  for  corporations,  questions  as  to  what  are  and  are  not 
necessary  expenses  to  obtain  and  retain  the  good-will  of  customers  will 
not  be  decided  by  the  Commissioner  of  Internal  Revenue  but  by  the 
courts.  Until  such  decision,  corporations  will  continue  to  deduct  all 
those  expenses  necessary  to  properly  maintain  their  businesses.  This 
is  in  accordance  with  the  law  and  with  common  sense. 

Compensation  Based  on  Stockholdings 

Amounts  paid  as  compensation  or  additional  compensation  to  offi- 
cers or  employees,  which  amounts  are  based  upon  the  stockholdings 
of  such  officers  or  employees,  are  held  to  be  dividends,  and  although 
paid  in  lieu  of  salaries  or  wages,  are  not  allowable  deductions  from 
gross  income,  for  the  reason  that  dividends  are  not  deductible. 

Here,  of  course,  the  burden  of  proof  is  on  the  government  to  show 
that  salaries  and  vv ages  are  not  reasonable.  If  reasonable  in  the  opinion 
of  the  board  of  directors,  the  full  amounts  paid  should  be  deducted 
among  expenses. 


836  AUDITING 

Donations  for  Welfare  of  Employees 

Donations  by  corporations  which  legitimately  represent  a  considera- 
tion for  a  benefit  flowing  directly  or  indirectly  to  the  corporations  as  an 
incident  of  its  business  are  allowable  deductions  from  gross  income  in 
ascertaining  net  income  subject  to  the  income  tax,  as  donations  to  a 
hospital  upon  consideration  that  employees  of  the  corporation  are  to 
have  a  ward  for  their  use  in  case  of  accident  or  illness.  The  absence 
of  consideration  moving  in  some  form  to  the  corporation  will  make  a 
contribution  a  mere  gratuity.     (T.  D.  2090.) 

Donations  made  for  purposes  connected  with  the  operation  of  the 
property  when  limited  to  charitable  institutions,  hospitals,  or  educa- 
tional institutions,  conducted  for  the  benefit  of  the  employees  of  a  cor- 
poration, or  their  dependents,  shall  be  proper  as  a  deduction  under  the 
head  of  expense  in  the  return  of  the  corporation.     (T.  D.  2090.) 

Gifts  of  Merchandise 

Probably  every  retailer  is  requested  to  make  gifts  to  charitable  and 
religious  organizations.  Usually  the  solicitor  is  a  good  customer  and 
the  donation  is  made.  The  author  has  never  heard  it  seriously  con- 
tended that  gifts  of  this  nature  were  other  than  expenses  of  doing 
business,  and  of  course,  they  are,  and  should  be,  so  treated  in  income 
tax  returns. 

The  Department,  however,  would  probably  rule  that  they  are  some 
other  kind  of  expenditure  and  not  allowable  deductions. 

Corporations  as  a  rule  do  not  make  payments  representing  "mere 
gratuities"  but  expect  and  receive  some  consideration  for  expenditures 
of  a  quasi-charitable  nature.  Inspectors  have  mentioned  to  the  author 
that  they  are  expected  to  discover  many  thousands  of  dollars  of  addi- 
tional taxes,  and  this  may  account  for  such  items  as  gifts  to  hospitals 
being  thrown  out  as  allowable  deductions.  As  soon  as  the  courts  pass 
on  the  word  "expenses"  as  used  in  the  law,  all  items  of  this  nature 
will  be  found  to  be  deductible. 

Interest  on  Indebtedness  Wholly  Secured  by  Collateral  the  Subject 
of  Sale  in  Ordinary  Business 

As  to  this  the  law  says: 

In  case  of  indebtedness  wholly  secured  by  collateral  the  subject 
of  sale  in  ordinary  business  of  such  corporation,  joint-stock  com- 
pany, or  association,  the  total  interest  secured  and  paid  by  such 
company,  corporation,  or  association  within  the  year  on  any  such  in- 
debtedness may  be  deducted  as  a  part  of  its  expense  of  doing  business. 

The  following  extracts  are   from  Treasury  Department  decisions : 

Many  inquiries  come  from  corporations  engaged  in  buying  and  sell- 
ing real  estate,  which  real  estate  is  pledged  for  the  payment  of  in- 


FEDERAL    INCOME    TAX  837 

debtedness,  and  the  question  submitted  is  whether  or  not  such  real 
estate  is  "collateral"  within  the  meaning  of  the  proviso  quoted  and 
whether  or  not  corporations  paying  interest  on  indebtedness  wholly 
secured  by  such  collateral  may  deduct  from  gross  income  as  ''an  ex- 
pense of  doing  business"  the  amount  of  interest  paid  on  such  indebted- 
ness. 

Relative  to  this  you  are  informed  that  "collateral,"  as  used  in  this 
proviso,  comprehends  and  includes  real  estate  or  any  form  of  physi- 
cal or  tangible  property  bound  for  the  performance  of  certain  cove- 
nants, the  payment  of  certain  obligations,  and  if  such  real  estate  or 
other  physical  or  tangible  property  is  the  ''subject  of  sale  in  the  ordi- 
nary business  of  the  corporation"  owning  the  same,  that  is,  if  such 
corporation  is,  as  a  matter  of  its  ordinary  business,  engaged  in  buy- 
ing and  selling,  or  dealing  in  such  property,  the  interest  actually  paid 
within  the  year  on  indebtedness  wholly  secured  by  such  collateral  (a 
mortgage  on  such  property)  may  be  allowably  deducted  from  gross 
income  under  item  4  (a)  of  the  return  form  as  an  expense  of  doing 
business,  without  regard  to  the  limit  of  deductible  interest  as  set  out 
in  subdivision  "Third,"  paragraph  (b),  subsection  G  of  the  law  here- 
inbefore cited. 

This  construction  of  the  proviso  quoted  is  not  intended  to  and 
does  not  authorize  the  deduction  as  "an  expense  of  doing  business" 
of  any  interest  paid  or  indebtedness  secured  by  property,  real  or  per- 
sonal, which  is  not  the  "subject  of  sale  in  the  ordinary  business  of 
the  corporation,"  but  which  is  held  by  it  for  the  purpose  of,  or  as 
an  instrument  in  carrying  on,  its  ordinary  business — such  as  the  rights 
of  way  and  other  property  of  public  utility  companies,  permanent  office 
buildings  and  property  of  like  character  held  or  occupied  for  their 
own  particular  use  or  purpose  in  the  furtherance  of  the  objects  of  the 
corporation,  but  which  property  is  not  the  subject  of  sale  in  their 
ordinary  business,  and  which  is  simply  occupied  or  used  as  an  in- 
strument or  means  of,  or  essential  to,  the  carrying  on  of  the  ordinary 
business  for  the  transaction  of  which  they  are  organized.  The  fact 
that  such  property  may  be  subject  to  sale  under  extraordinary  or 
peculiar  conditions  does  not  qualify  but  rather  disqualifies,  it  as 
"collateral"  such  as  is  contemplated  by  this  provision  of  the  act  cited. 

The  only  corporations,  joint-stock  companies,  or  associations,  which 
will  be  allowed  under  this  proviso,  as  herein  interpreted,  to  deduct 
as  "an  expense  of  doing  business"  interest  paid  on  indebtedness  wholly 
secured  by  mortgage  on  real  estate,  or  other  physical  and  tangible 
property,  are  those  corporations,  joint-stock  companies,  or  associations, 
which  are  organized  and  operated  for  the  exclusive  purpose  of  buy- 
ing, selling,  and  dealing  in  the  particular  kind  of  property  upon  which 
the  mortgage  is  given,  and  the  particular  property  pledged  for  the 
debt  upon  which  the  interest  is  paid  must  be  the  "subject  of  sale  in 
the  ordinary  business  of  the  corporation." 

Any  corporation  whose  indebtedness  is  secured  by  a  trust  mort- 
gage or  by  any  form  of  indenture  which  covers  and  includes  in  the 
lien  any  property  which  is  not  the  subject  of  sale  in  the  ordinary 
business  of  such  corporation,  will  be  and  is  excluded  from  the  benefit 
of  this  proviso,  as  hereinbefore  construed,  and  its  interest  deduction 
will  be  limited  to  the  amount  authorized  in  subdivision  "Third"  above 
referred  to— that  is,  the  interest  actually  paid  within  the  year,  at  the 
contract  rate,  on  an  amount  of  bonded  or  other  indebtedness  at  no 


838  AUDITING 

time  within  the  year  in  excess  of  a  sum  ascertained  by  adding  to  the 
paid-up  capital  stock  outstanding  at  the  close  of  the  year  one-half  of 
the  total  amount  of  the  interest-bearing  indebtedness  also  then  out- 
standing. 

Corporations  which  under  this  ruling  are  entitled  to  deduct  as  "an 
expense  of  doing  business"  the  total  amount  of  interest  paid  within 
the  year  on  "indebtedness  wholly  secured  by  collateral  the  subject  of 
sale  in  the  ordinary  business  of  such  corporations,"  are  required  to 
state  separately  in  their  returns  the  amount  of  indebtedness  upon 
which  such  interest  is  paid,  segregating  it  from  the  indebtedness  not 
so  secured  and  upon  which  the  interest  paid  is  taken  credit  for  or 
deducted  under  item  6  (a)  of  the  return  form.  The  interest-bearing 
indebtedness  stated  under  item  2  of  the  return  form  as  one  of  the 
bases  for  determining  the  amount  of  interest  which  may  be  allowably 
deducted  under  item  6  (a)  must  not  include  any  "indebtedness  wholly 
secured  by  collateral  the  subject  of  sale  in  the  ordinary  business  of 
the  corporation."  Failure  to  segregate  the  two  forms  of  indebtedness 
will  render  the  interest  deduction  under  item  6  (a)  subject  to  sus- 
pension and  disallowance.     (T.  D.  1993.) 

As  used  in  the  act,  the  expression  "collateral  the  subject  of  sale," 
etc.,  refers  to  physical  or  tangible  property  bound  for  the  performance 
of  certain  covenants  or  payment  of  certain  obligations,  and  which 
physical  or  tangible  property  is  the  "subject  of  sale  in  the  ordinary 
business  of  a  corporation"  owning  the  same.  Where  such  corporation 
is,  as  a  matter  of  its  ordinary  business,  engaged  in  buying  and  sell- 
ing, or  dealing  in  such  property,  the  interest  actually  paid  within  the 
year  on  indebtedness  wholly  secured  by  such  collateral  may  be  al- 
lowably deducted  from  gross  income  as  an  expense  of  doing  business, 
without  regard  to  the  limit  of  deductible  interest  as  otherwise  pro- 
vided by  the  statute.  The  corporation,  etc.,  must  be  organized  and 
operated  for  the  purpose  of  buying,  selling,  and  dealing  in  the  par- 
ticular kind  of  property  which  becomes  the  collateral  in  question,  and 
the  particular  property  pledged  for  the  debt  upon  which  the  interest 
is  paid  must  be  the  "subject  of  sale  in  the  ordinary  business  of  the 
corporation."  Real  estate  mortgages,  and  the  property  of  corporations 
organized  for  and  engaged  in  the  business  of  buying,  selling,  and  deal- 
ing in  real  estate ;  warehouse  receipts  representing  property  the  sub- 
ject of  sale  in  the  ordinary  business  of  the  corporation  owning  the 
same,  and  which  warehouse  receipts  are  pledged  as  collateral  for  such 
corporation's  own  debt,  are  examples  where  the  interest  paid  will  be 
deductible  as  a  "business  expense"  and  not  be  subject  to  the  statutory 
limitation  as  to  interest  deduction.     (T.  D.  2090.) 

Rentals 

Interest  paid  pursuant  to  contract  on  an  indebtedness  secured  by 
mortgage  on  real  estate  occupied  and  used  by  a  corporation,  in  which 
real  estate  the  corporation  has  no, equity  or  to  which  it  is  not  taking 
title  is  an  allowable  deduction  from  gross  income  as  a  rental  charge, 
payment  of  which  is  required  to  be  made  as  a  condition  to  the  con- 
tinued use  and  possession  of  the  property. 

This  is  a  very  important  distinction,  as  there  is  no  limit  to  the 
amount  of  rental  payments,  for  which  credit  may  be  claimed,  so  long 


FEDERAL    INCOME    TAX 


839 


as  the  propriety  of  the  payments  themselves  is  unquestioned,  whereas 
there  is  a  definite  limit  to  the  amount  of  interest  payments  for  which 
credit  will  be  allowed.  Especially  will  public  service  corporations 
which  hold  part  or  all  of  the  property  under  leases  providing  that  as 
rental  the  lessee  shall  pay  the  interest  on  bonds  or  a  guaranteed  divi- 
dend on  stock  of  the  lessor  company  outstanding  at  the  time  of  making 
the  lease,  find  this  construction  of  these  payments  as  rentals  to  be  a 
most  important  subject  for  consideration  when  making  their  income 
tax  returns. 

Losses 
Bond  Discount 

Where  a  corporation  sells  bonds  at  less  than  par  it  is  because  the 
nominal  rate  of  interest  as  expressed  in  the  bonds  is  less  than  the 
effective  rate  actually  realized.  In  other  words,  if  a  corporation  has  a 
high  credit  and  there  is  a  favorable  market  for  securities,  it  will  secure 
the  advantage  of  a  low  rate  of  interest.  Its  5  per  cent  bonds  may 
sell  at  110,  but  if  its  credit  is  not  so  high  and  the  market  is  not  so 
favorable,  its  5  per  cent  bonds  may  sell  at  90.  In  both  cases  it  is  the 
effective  interest  rate  in  force  at  the  time  which  governs  the  price  of 
the  bonds.  Therefore,  proper  accounting  calls  for  a  reflection  of  the 
effective  or  actual  rate  spread  over  the  life  of  the  bonds,  and  this  is 
readily  accomplished  by  adjusting  the  interest  account  to  correspond. 

The  Commissioner  has  ruled  that  discount  on  bonds  is  a  loss  and 
may  be  deducted  under  item  5  (a).  His  position  is  shown  in  the 
following  correspondence : 

Replying  to  your  letter  asking  for  a  decision  on  the  following 
question:  "A  corporation  sells  a  bond  issue  at  90,  the  bonds  running 
say,  twenty  years,  when  is  it  proper  for  the  corporation  to  charge  off 
the  loss  or  discount  of  ten  points?"  you  are  advised  that  such  bond 
discount  should  be  prorated  over  the  life  of  the  bonds  and  the  pro- 
portionate part  applicable  to  each  year  deducted  in  preparing  the  re- 
turn of  annual  net  income  for  that  year.  In  the  case  you  cite,  1/20 
of  such  discount  may  be  deducted  in  each  year.  The  deduction  from 
gross  income  on  this  account  should  be  made  under  item  5  (a) — 
"Losses  Sustained." 

In  this  connection  you  are  informed  that  a  discount  on  an  issue 
of  bonds  issued  prior  to  the  year  1909  and  such  discount  charged 
against  the  income  of  the  year  when  issued,  is  considered  a  closed 
transaction  and  no  prorated  part  of  such  discount  can  now  be  con- 
sidered an  allowable  deduction  from  gross  income  in  arriving  at  the 
net  income  for  a  taxable  period. 

A  similar  position  is  taken  with  respect  to  bonds  purchased  at  a 
premium. 


840  AUDITING 

Losses  Incurred  by  the  Retirement  of  Bonds 
Ruling  by  the  Internal  Revenue  Bureau : 

^  This  office  is  in  receipt  of  your  letter  stating  the  following  propo- 
sition and  requesting  the  ruling  of  the  Department  thereon : 

"Under  the  terms  of  its  indenture  securing  an  issue  of  bonds,  a 
corporation  is  required  annually  to  purchase  and  retire  a  certain  num- 
ber of  said  bonds.  If  the  said  corporation^  when  purchasing  in  the 
market  the  required  bonds  so  to  be  retired,  is  compelled  to  pay  more 
than  par  for  said  bonds,  is  it  entitled  to  deduct  as  a  loss  in  that 
year  the  difference  between  the  amount  paid  and  the  par  value  of  the 
bonds,  such  difference  being  charged  off  as  a  loss  on  its  books?" 

In  reply,  you  are  advised  that  the  question  presented  may  be  viewed 
from  different  angles  according  to  the  circumstances  connected  with 
the  issuing  of  the  bonds. 

If  the  bonds  were  issued  at  par,  then  the  corporation  may  deduct 
the  difference  between  par  and  the  price  at  which  purchased  for  retire- 
ment. 

If  the  bonds  were  issued  at  a  premium  and  such  premium  accounted 
for  as  income  for  the  year  in  which  issued,  then  the  difference  between 
par  and  the  purchase  price  may  be  deducted  as  a  loss,  but  if  the  pre- 
mium at  which  the  bonds  were  issued  had  not  been  carried  into  in- 
come account,  then  the  loss  to  be  claimed  should  be  the  difference 
between  the  price  at  which  the  bonds  were  issued  and  the  purchasing 
price. 

In  the  event  that  the  bonds  were  issued  at  a  discount  and  the  dis-. 
count  was  charged  against  the  earnings  of  the  year  in  which  issued, 
the  difference  between  par  and  the  purchase  price  may  be  deducted 
as  a  loss,  but  if  the  discount  on  the  bonds  was  prorated  over  the  life  of 
the  bonds  and  the  annual  proportion  charged  against  the  yearly  income, 
the  amount  to  be  charged  off  as  a  loss  for  the  year  in  which  the  bonds 
are  purchased  for  retirement  should  be  the  difference  between  the  price 
at  which  the  bonds  were  issued  and  the  purchase  price  minus  an  allow- 
ance for  the  sums  that  had  been  charged  off  annually  on  account  of  the 
prorated  discount  on  such  bonds. 

Interest 

The  law  provides  as  a  deduction : 

The  amount  of  interest  accrued  and  paid  within  the  year  on  its 
indebtedness  to  an  amount  of  such  indebtedness  not  exceeding  one-half 
of  the  sum  of  its  interest-bearing  indebtedness  and  its  paid-up  capital 
stock  outstanding  at  the  close  of  the  year,  or  if  no  capital  stock,  the 
amount  of  interest  paid  within  the  year  on  an  amount  of  its  indebted- 
ness not  exceeding  the  amount  of  capital  employed  in  the  business  at 
the  close  of  the  year. 

Preferred  Stock 

Preferred  stock  is  not  a  liability,  hence  cannot  be  treated  as  interest- 
bearing  indebtedness. 

Dividends  upon  preferred  stock  are  not  payments  of  interest  and  no 
deduction  in  respect  thereof  is  proper. 


FEDERAL    INCOME    TAX  84 1 

The  Commissioner  of  Internal  Revenue,  in  his  report  of  December 
6,  1915,  stated  that  a  great  many  corporations  have  treated  preferred 
stock  as  interest-bearing  indebtedness,  and  the  payments  of  dividends  as 
the  equivalent  of  interest  payments.  No  good  accountant  would  sanc- 
tion such  practice,  but  in  view  of  the  Commissioner's  statement  the  law 
should  be  amended  to  accord  with  proper  practice. 

The  regulations  and  decisions  state  infer  alia: 


"Paid-up  capital  stock  outstanding  at  the  close  of  the  year,"  when 
used  in  connection  with  "interest-bearing  indebtedness,"  to  determine 
the  maximum  principal  upon  which  interest  for  the  purpose  of  an 
authorized  deduction  is  to  be  computed,  means  the  par  value  of  shares 
issued  as  reported  in  item  1  of  the  return  form,  and  will  not  include 
the  surplus  carried  by  the  corporation. 

Full  amount  of  stock,  as  represented  by  the  par  value  of  the  shares 
issued,  is  to  be  regarded  as  the  paid-up  capital  stock,  except  when  such 
stock  is  assessable  on  account  of  deferred  payments,  or  payable  in 
instalments,  in  which  case  the  amount  actually  paid  on  such  shares 
will  constitute  the  actual  paid-up  capital  stock  of  the  corporation. 

The  interest  to  be  deductible  must  have  been  computed  on  the 
proper  principal  at  the  contract  rate  and  must  have  been  actually  paid 
within  the  year. 

Interest  paid  pursuant  to  contract  on  an  indebtedness  secured  by 
mortgage  on  real  estate  occupied  and  used  by  a  corporation,  in  which 
real  estate  the  corporation  has  no  equity  or  to  which  it  is  not  taking 
title,  is  an  allowable  deduction  from  gross  income  as  a  rental  charge, 
payment  of  which  is  required  to  be  made  as  a  condition  to  the  con- 
tinued use  and  possession  of  the  property.  If,  however,  the  corpora- 
tion has  an  equity  in  or  is  purchasing  for  its  own  use  the  real  estate 
upon  which  such  mortgage  is  a  prior  lien,  the  indebtedness  will  be 
held  to  be  indebtedness  of  the  corporation  within  the  meaning  of 
the  law  and  the  interest  paid  on  such  mortgage  will  be  deductible  only 
to  the  extent  that  it,  with  interest  on  other  obligations  of  the  corpora- 
tion, is  within  the  limit  fixed  by  the  act. 

It  is  held  that  in  the  case  of  a  corporation  having  capital  stock,  this 
deductible  interest  is  interest  actually  accrued  and  paid  within  the 
year,  on  an  amount  of  indebtedness  not  exceeding  the  paid-up  capital 
stock  outstanding  at  the  close  of  the  year,  increased  by  the  addition 
thereto  of  one-half  the  interest-bearing  indebtedness  outstanding  at 
the  close  of  the  year. 

The  qualifying  phrase  "outstanding  at  the  close  of  the  year"  ap- 
pearing in  the  foregoing  quotation,  is  held  to  apply  to  both  paid-up 
capital  stock  and  indebtedness,  and  "one-half  the  sum  of"  qualifies 
only  the  indebtedness,  which  indebtedness,  like  the  paid-up  capital 
stock,  is  required  by  the  law  to  be  reported,  in  making  return  of 
annual  net  income,  as  outstanding  at  the  close  of  the  year. 

If  no  indebtedness  is  outstanding  at  the  close  of  the  year,  the  maxi- 
mum deduction  allowable  on  account  of  interest  paid,  will  be  the 
amount  of  interest  actually  accrued  and  paid  on  an  amount  of  indebted- 
ness not  exceeding  at  any  time  within  the  year,  the  entire  paid-up 
capital  stock  outstanding  at  the  close  of  the  taxable  year,  that  is,  in 
such  case,  the  paid-up  capital  stock  outstanding  at  the  close  of  the 


842  AUDITING 

year,  measures  the  highest  amount  of  indebtedness  upon  which  de- 
ductible interest  can  be  computed. 

For  the  purpose  of  an  allowable  deduction,  interest  on  the  maxi- 
mum amount  of  indebtedness,  determined  in  the  manner  above  indi- 
cated, can  be  computed  upon  such  amount  only  for  the  time  during 
which  such  amount  of  indebtedness  is  not  in  excess  of  the  paid-up 
capital  stock  increased  by  one-half  the  sum  of  the  interest-bearing  in- 
debtedness outstanding  at  the  close  of  the  year. 

In  any  event,  the  amount  of  interest,  in  order  to  constitute  an 
allowable  deduction,  must  not  only  be  within  the  limit  of  the  law 
as  herein  defined,  but  must  have  actually  accrued  and  been  paid  within 
the  year  for  which  the  return  is  made. 

In  cases  where  no  capital  stock  exists,  the  limitation  as  to  deduction 
is  confined  to  interest  actually  paid  on  an  amount  of  indebtedness  not 
exceeding  at  any  time  during  the  year,  the  capital  employed  in  the 
business  at  the  close  of  the  year. 

Interest  on  bonded  or  other  indebtedness  bearing  different  rates  of 
interest  may  be  deducted  from  gross  income  during  the  year,  pro- 
vided the  aggregate  amount  of  such  indebtedness  on  which  the  in- 
terest is  paid  does  not  exceed  the  limit  prescribed  by  law,  and  in 
case  the  indebtedness  is  in  excess  of  the  amount  on  which  interest 
may  be  legally  deducted,  the  indebtedness  bearing  the  highest  rate 
may  be  first  considered  in  computing  the  interest  deduction  and  the 
balance,  if  any,  will  be  computed  upon  the  indebtedness  bearing  the 
next  lower  rate  actually  paid,  and  so  on  until  interest  on  the  maximum 
principal  allowed  has  been  computed. 


The  limitation  in  the  law  is  indefensible.  Corporations  should  be 
permitted  to  deduct  all  interest  paid  on  indebtedness. 

Individuals  are  permitted  to  deduct  "all  interest  paid  within  the 
year  by  a  taxable  person  on  indebtedness."  The  discrimination  against 
corporations  in  this  respect  is  hard  to  understand.  Either  no  interest 
should  be  deductible  or  all  interest  should  be  an  allowable  deduction. 
An  arbitrary  selection  of  "one-half,"  etc.,  is  simply  ridiculous.  It  is 
also  an  inducement  to  excessive  capitalization. 

Whatever  reasons  may  have  existed  under  the  corporation  tax  law 
for  considering  interest  paid  on  indebtedness  as  a  distribution  of  net 
income,  have  disappeared  under  the  income  tax  law.  By  the  terms  of 
the  former  act  the  individual  recipient  of  the  interest  was  not  taxable ; 
under  the  present  act  he  is. 

To  tax  a  corporation  on  an  amount  of  income  accrued  to  it,  and 
then  to  tax  the  same  amount  again  upon  its  payment  to  the  recipient, 
is  not  equitable.  If  there  is  any  logical  reason  for  exempting  dividends 
from  the  normal  tax  because  the  corporation  has  paid  a  tax  on  the 
income  represented  thereby,  that  reason  applies  with  equal  force  to  in- 
terest disbursements  from  income  on  which  the  corporation  has  been 
taxed.  Conversely,  if  the  owner  of  the  evidence  of  indebtedness  is  to  be 
taxed  on  the  interest  he  receives,  the  corporation  should  be  permitted  to 


FEDERAL    INCOME    TAX 


843 


pass  to  him  that  part  of  its  income  represented  by  such  interest,  without 
the  imposition  of  an  intermediate  tax  an  the  corporation. 

If  no  change  is  made  in  this  respect,  corporations  may  find  it  ad- 
vantageous to  change  their  fiscal  years  to  dates  when  their  indebtedness 
is  largest,  as  by  so  doing  they  can  secure  a  larger  allowable  deduction. 

Taxes 

The  regulations  refer  to  tax  deductions  as  follows: 

Reserves  for  Taxes  Are  Not  Deductible.  Reserves  for  taxes  can- 
not be  allowed  as  the  law  specifically  provides  that  only  such  sums 
as  are  paid  within  the  year  for  taxes  shall  be  deducted. 

Deductions  for  taxes,  however,  should  be  the  aggregate  of  the 
amounts  actually  paid,  as  shown  on  the  cash  book  of  the  corporation. 

Certain  Taxes  Are  Not  Deductible.  Taxes  paid  for  local  benefit* 
are  not  deductible. 

Taxes  paid  by  a  corporation  pursuant  to  a  contract  guaranteeing 
that  the  interest  payable  on  its  bonds  or  other  indebtedness  shall  be 
free  from  taxation  are  not  deductible. 

Import  duties  or  taxes  are  not  deductible  under  the  item  of  taxes 
paid  during  the  year,  but  should  be  included  in  arriving  at  the  cost 
of  "goods  under  item  4  (expenses). 

Corporations  with  "tax-free"  provisions  in  their  bonds  can  save 
money  by  close  attention  to  the  exemption  certificates  filed  with  them. 
Many  bondholders  do  not  trouble  to  claim  exemption  where  interest 
is  "tax  free,"  because  their  gross  income  is  less  than  $3,000  and  they 
know  they  do  not  have  to  pay  a  tax  in  any  event.  Therefore,  where 
feasible,  and  the  recipient  is  entitled  to  exemption,  certificates  claiming 
exemption  should  be  secured  and  substituted  for  those  not  claiming 
exemption. 

Supplementary  Statement  for  Corporations 
Deductions 

The  classification  of  expenses  called  for  by  Form  1031  revised,  has 
been  more  burdensome  to  taxpayers  than  is  justifiable.  Corporations 
with  good  accounting  systems  are  most  affected,  while  those  with  poor 
systems  find  it  easier  to  comply  with  the  requirements. 

It  would  seem,  however,  that  the  Internal  Revenue  Commissioner 
is  concerned  chiefly  with  securing  a  somewhat  more  detailed  classifica- 
tion of  expenses  than  was  originally  contemplated,  and  he  shows  a 
willingness  to  accept  a  different  classification  from  that  shown  on  the 
form,  provided  the  items  are  as  informative  as  the  Commissioner  re- 
quires. 

The  following  extract  from  correspondence  bears  directly  on  this 
point.    The  Commissioner  said  in  answer  to  an  inquiry: 


844  AUDITING 

In  reply  to  your  request  that  the  railway  companies  which  you 
represent  be  permitted  to  file  a  schedule  of  the  deductions  allowed 
under  the  law  in  conformity  \Vith  the  uniform  system  of  accounts 
ordered  by  the  Public  Service  Commission,  instead  of  the  division 
indicated  by  the  return,  you  are  informed  that  the  division  indicated 
in  the  supplementary  statement  forming  a  part  of  the  return  is  merely 
suggestive.  This  office  desires  information,  as  far  as  possible  in  detail, 
as  to  what  items  go  to  make  up  the  general  expenses. 

If  this  information  is  sufficiently  given  in  detail  in  the  schedule  of 
deductions  allowed  under  the  law  in  conformity  with  the  uniform 
system  of  accounts  ordered  by  the  Public  Service  Commission,  this 
office  has  no  objection  to  such  a  statement  being  attached  to  the  return. 

It  should  be  understood,  however,  that  this  permission  does  not 
carry  with  it  a  ruling  that  all  of  the  items  included  in  such  schedule 
will  be  held  to  be  allowable  deductions  from  gross  income  for  the 
purposes  of  the  income  tax. 

And  in  answer  to  another  inquiry: 

This  office  does  not  desire  to  cause  corporations  any  unnecessary 
trouble  or  expense  in  preparing  the  supplementary  statement  referred 
to  and  therefore  if  the  books  of  the  corporation  which  you  represent 
are  kept  in  such  a  manner  as  to  make  it  very  difficult  to  give  the  in- 
formation in  the  exact  form  called  for  on  the  supplementary  state- 
ment, a  reasonable  explanation  in  detail  of  the  manner  of  arriving  at 
gross  income  and  expenses  will  be  accepted.  However,  it  is  desired 
that  this  information  shall  be  furnished  in  such  a  manner  that  the 
returns  can  be  intelligently  audited  upon  receipt  thereof  in  this  office. 

If  the  Treasury  Department  will  adopt  and  enforce  reasonable  rules 
only,  and  will  conform  to  modern  accounting  practice  in  the  adminis- 
tration of  the  law  (the  success  of  which  depends  upon  honest  and 
accurate  accounts),  then  corporations  can  be  depended  upon  for  full 
and  complete  co-operation  in  the  compilation  of  returns  and  the  pay- 
ment of  taxes. 

DEDUCTION  OF  TAX  AT  SOURCE  OF  INCOME 

Present  Method  of  Deduction 

The  framers  of  the  law  have  followed  to  a  certain  extent  the 
British  precedent  of  deducting  the  tax  at  the  source  of  the  income 
wherever  feasible.  This  is  accomplished  by  requiring  all  persons 
or  firms,  corporations  and  associations,  whether  acting  for  themselves 
or  on  behalf  of  some  one  else,  to  deduct  the  normal  tax  of  1  per 
cent  from  payments  of  "interest,  rents,  salaries,  wages,  premiums,  an- 
nuities, compensation,  remuneration,  emoluments,  or  other  fixed  or  de- 
terminable annual  gains,  profits,  and  income  of  another  person  exceed- 
ing $3,000  for  any  taxable  year" ;  and  pay  such  tax  over  to  the  govern- 
ment. 


FEDERAL    INCOME    TAX 


845 


The  tax  is  to  be  deducted  and  paid  over  to  the  government  from 
.all  payments  of  interest  on  bonds  and  mortgages,  or  deeds  of  trust, 
or  other  similar  obligations  of  corporations,  whether  payable  annually 
or  at  shorter  or  longer  periods,  irrespective  of  whether  or  not  such 
interest  payments  amount  to  $3,000. 

The  tax  must  also  be  deducted  from  all  collections  of  interest  and 
dividends  (irrespective  of  amount)  on  foreign  bonds  and  stocks  not 
payable  in  the  United  States. 

Another  form  of  collection  at  the  source  arises  out  of  the  taxation 
of  1  per  cent  upon  the  net  income  of  corporations,  the  dividends  out 
of  which  are  afterwards  exempt  so  far  as  the  normal  tax  of  individuals 
is  concerned. 

There  are  certain  exceptions  to  the  foregoing  requirements,  e.g.,  tax 
is  not  to  be  deducted  from  payments  to  corporations,  nor  where  exemp- 
tion is  properly  claimed,  nor  where  bonds  are  "tax  free."  The  corpora- 
tion which  issues  "tax-free"  bonds  does  not  withhold  the  tax  on  the 
interest  payments  but  pays  it  to  the  government  as  if  it  had  deducted  it. 

The  regulations  and  procedure  in  connection  with  deduction  at  the 
source  are  complicated  and  of  no  general  interest.  Rather  than  attempt 
to  master  all  of  the  numerous  regulations  and  decisions,  it  will  be 
easier,  where  any  doubt  obtains  as  to  the  procedure  in  a  given  case, 
to  consult  one's  local  bank  or  internal  revenue  collector. 

Excessive  Cost  of  Collection  at  Source 

The  report  to  the  National  Tax  Association  suggests  a  much 
better  method  of  procedure,  as  follows: 

That  Part  of  the  Act  Which  Requires  the  Collection  of  the  Tax 
AT  THE  Source  Should  be  Modified. 

It  is  morally  wrong  that  the  government  should  force  corporations 
and  individuals  who  by  accident  of  circumstance  have  control  over  the 
payment  to  others  of  interest,  rent,  salaries,  wages,  premiums,  annuities, 
compensation,  remuneration,  emoluments,  or  other  fixed  or  deter- 
minable annual  gains,  profits,  and  income,  to  perform  the  work  of 
collection  which  properly  belongs  to  the  government  and  to  bear  with- 
out compensation  a  great  part  of  the  expense  of  collecting  the  tax. 

It  might  be  claimed  that  this  objection  can  be  removed  by  the 
government  agreeing  to  reimburse  the  original  taxpayers  for  their 
outlay.  It  would,  however,  be  exceedingly  cumbersome  for  the  govern- 
ment to  make  such  an  arrangement  and  there  would  be  grave  danger 
of  abuse.  Moreover,  even  if  such  an  arrangement  was  made,  the  objec- 
tion would  be  only  in  part  removed.  For  the  real  difficulty  with  the 
scheme  is  the  excessive  cost  of  collection,  whether  this  cost  be  defrayed 
by  the  government  or  by  the  taxpayer. 

It  is  true  that  since  the  law  first  went  into  operation,  there  has 
been,  as  might  be  expected,  some  reduction  in  the  cost  of  collecting 


846 


AUDITING 


the  tax ;  but  it  is  still  excessive.  Your  Committee  has  instituted  a 
careful  inquiry  into  this  matter  and  finds  the  facts  to  be  as  follows : 

A  group  of  financial  institutions  who  act  as  pa5'ing  agents  or  fiscal 
agents  for  corporations,  report  that  the  cost  of  collecting  the  tax 
ranges  from  10  per  cent  to  20  per  cent  of  the  amount  turned  over 
to  the  government.  The  variation  is  doubtless  due  partly  to  the  fact 
that  where  bonds  are  tax-exempt  the  work  of  handling  certificates  is 
much  less  than  where  the  corporation  does  not  assume  the  tax,  and 
certificates  have  to  be  handled  with  the  greatest  care.  If  ^most  of  the 
bond  issues  on  which  a  trust  company  pays  interest  are 'tax-exempt, 
the  cost  is  naturally  lower  than  in  the  other  case.  That  the  maximum 
figure  of  20  per  cent  is  not  excessive  for  many  companies  is  very 
certain.  With  one  large  company  the  Committee  has  been  able  to  go 
over  the  details  of  the  calculation,  and  finds  that  the  additional  clerical 
assistance  occasioned  by  the  law  has  been  from  $5,000  to  $7,000,  and 
that  the  total  tax  collected  has  been  $35,000  per  annum.  This  figure 
of  the  cost  does  not  take  into  account  incidental  items  other  than  clerk 
hire,  or  include  overhead  charges. 

A  number  of  small  banks  and  trust  companies  which  do  not  act 
as  paying  agents  report  an  insignificant  amount  of  tax  collected  and 
an  insignificant  cost  of  collection.  The  law  has  occasioned  them  some 
trouble,  and  much  of  it  unnecessary ;  but  they  are  unable  to  estimate 
the  expense,  and  say  that  neither  the  expense  nor  the  tax  is  of  any 
importance. 

From  a  number  of  corporations,  railroads,  other  public  service  com- 
panies, and  manufacturing  corporations,  the  Committee  has  received 
data  showing  the  cost  of  collection  ranging  from  1  per  cent  to  70  per 
cent.  The  figure  of  1  per  cent  was  given  by  a  large  corporation,  the 
bonds  of  which  are  tax-free;  but  it  is  exclusive  of  any  additional  cost 
imposed  upon  fiscal  agents.  At  the  other  end  of  the  scale  is  another 
corporation,  none  of  whose  issues  are  tax-free,  which  reports  the  cost 
of  collection  in  excess  of  70  per  cent.  It  pays  its  coupons  over  the 
counter;  and  this  figure  probably  shows  the  whole  cost  of  collection, 
since  there  is  no  paying  agent. 

Most  of  the  data  secured  by  the  Committee  show  costs  of  collection 
running  from  10  per  cent  to  20  per  cent,  whether  they  are  obtained 
from  banks  or  from  debtor  corporations.  These  figures  are  confirmed 
by  other  evidence.  We  are  informed  that  since  the  income  tax  went 
into  operation,  paying  agents  have  very  generally  increased  their 
charge  for  paying  coupons  from  one-eighth  of  1  per  cent  to  one- 
fourth  of  1  per  cent,  and  corporations  have  accepted  such  increase 
as  reasonable. 

If  we  assume  that  this  increased  compensation  of  one-eighth  of  1 
per  cent  represents  the  additional  cost  which  the  law  occasions  to  the 
paying  agent  plus  a  reasonable  profit,  we  see  that  the  average  cost  to 
paying  agents  is  one-eighth  of  the  normal  tax  of  1  per  cent  less  what- 
ever allowance  may  be  made  for  profit.  If,  however,  a  large  number 
of  the  bonds  are  held  by  persons  with  incomes  of  less  than  $3,000,  the 
tax  will  not  equal  1  per  cent  of  the  interest  paid,  and  therefore  the 
figure  of  one-eighth  of  1  per  cent  may  mean  very  much  more  than 
one-eighth  of  the  amount  of  tax  received  by  the  government.  In 
general,  we  can  safely  say  that  the  cost  of  collecting  the  tax  on  bond 
interest  ranges  from  10  per  cent  to  20  per  cent,  and  in  a  large  number 
of  cases  is  nearer  the  larger  than  the  smaller  figure. 


FEDERAL    INCOME    TAX 


Other  Objections  to  Collection  at  Source 


847 


The  excessive  cost  of  collection  is  not  the  only  objection  to  the 
system  of  collection  at  the  source.  Among  the  other  shortcomings  are 
the  following: 

Collection  of  the  tax  at  the  source  enriches  the  government  wrong- 
fully at  the  expense  of  corporations  indebted  upon  coupon  or  registered 
bonds.  Where  the  corporation  has  assumed  and  agreed  to  pay  the  tax 
directed  by  the  act  to  be  withheld,  compliance  with  the  statute  requires 
it  to  pay  the  tax  in  cases  where  the  bondholder,  although  entitled  to 
an  exemption,  fails  or  refuses  to  file  a  claim  to  exemption.  The  debtor 
corporation  has  no  means  of  either  compelling  the  bondholder  to  claim 
such  exemption  or  of  ascertaining  whether  or  not  in  fact  he  is  entitled 
thereto.  Its  only  course  is  to  pay  to  the  government  an  amount  equivalent 
to  1  per  cent  of  the  amount  of  interest  paid  to  the  bondholder.  The 
amount  so  paid  may  or  may  not  be  a  tax  justly  due  the  government. 
Frequently  it  is  not.  Naturally,  it  is  impossible  to  gather  figures  to 
indicate  the  amount  which  is  so  paid,  not  as  a  tax  but  as  a  penalty. 
The  corporation  is  penalized  for  the  carelessness  or  perverseness  of  its 
bondholders.  It  is  not  an  answer  to  say  that  the  corporations  should 
never  have  entered  into  these  contracts.  The  contracts  have  served 
a  useful  purpose  in  relation  to  state  laws  where  the  bondholder  is 
taxed  and  the  corporation  through  its  treasurer  is  required  to  deduct 
and  to  collect  the  tax.  The  assumption  of  the  tax  by  the  corporation 
has  served  to  make  the  investment  more  attractive  and  has  no  doubt 
reacted  upon  the  interest  rate.  Such  contracts  are  now  in  no  small 
measure  a  necessity  in  bond  issues  intended  for  wide  distribution.  The 
investor  insists  upon  the  covenant  in  some  jurisdictions. 

Collection  at  the  source  in  its  relation  to  so-called  "tax-free" 
covenants  results  in  an  unjust  discrimination  between  bondholders 
under  the  same  mortgage.  Collection  at  the  source  is  required  only 
on  payment  of  interest  to  individuals.  Corporations  and  partnerships 
must  by  the  terms  of  the  act  be  paid  in  full  without  deduction  for  the 
tax.  The  debtor,  therefore,  under  an  agreement  with  all  of  its  bond- 
holders intended  to  operate  to  the  benefit  of  all  alike,  and  accepted 
with  that  understanding  by  the  investors,  is  compelled  by  the  terms 
of  the  act  co  pay  the  tax  for  those  of  its  bondholders  who  are 
individuals  but  not  for  corporations  or  partnerships.  Either  the  debtor 
corporation  should  be  required  to  assume  the  burden  of  the  tax  for  all 
of  its  bondholders — or,  as  this  committee  contends,  the  burden  should 
be  placed  where  it  properly  belongs,  that  is,  on  the  recipient  of  the 
income. 

Where  an  individual  is  an  investor  in  the  "tax-free"  bonds  of  two 
or  more  corporations,  and  his  aggregate  income  therefrom  exceeds 
$3,000,  if  single,  or  $4,000  if  married  and  living  with  his  wife,  he  may 
for  no  particular  reason,  throw  the  burden  of  the  tax  upon  any  one 
of  the  corporations  by  deliberately  refusing  to  claim  a  fair  proportion 
of  his  exemption  against  the  interest  he  receives  from  it.  He  is 
enabled  by  the  terms  of  the  act  to  work  injury  to  his  debtor,  and  the 
debtor  has  no  remedy  for  the  wrong.  If  he  receives  income  from  such 
bonds  and  also  from  other  sources,  the  act  permits  and  tacitly  en- 
courages him  to  throw  the  burden  of  the  tax  on  the  corporation  which 
pays  him  "tax-free"  interest,  and  to  claim  all  of  his  exemption  against 
other  income  from  sources  which  do  not  protect  him  by  "tax-free" 


848  AUDITING 

covenants.  As  a  result  he  enjoys  a  greater  exemption  from  the  tax 
than  that  to  which  he  is  entitled. 

There  is  no  attempt  on  the  part  of  your  Committee  to  advocate  on 
behalf  of  debtor  corporations  a  release  to  any  extent  from  the  respon- 
sibilities which  they  should  lawfully  assume  under  the  provisions  of 
the  covenants  here  discussed ;  but  it  does  contend  that  the  act  should 
not  enforce  a  partial  and  discriminatory  execution  of  such  contracts, 
nor  should  it  so  pervert  the  operation  of  the  contracts  as  to  cause  the 
corporation  to  be  unjustly  burdened  with  the  payment  of  moneys  which 
do  not  represent  the  tax,  or  which  represent  the  payment  of  more 
than  a  just  proportion  of  the  bondholder's  tax. 

The  covenants  in  terms  specify  that  the  corporations  will  pay  for 
the  bondholder  any  tax  which  it  is  required  to  withhold  and  deduct 
from  interest  payments.  Where  the  bondholder  is  subject  to  no  tax, 
the  corporation  should  pay  no  amount  to  the  government.  Where  the 
bondholder  has  other  income,  the  corporation  should  in  all  justice  be 
entitled  to  the  benefit  of  a  just  proportion  of  the  bondholder's  exemp- 
tion, for  the  tax  is  not  on  his  entire  income,  but  only  on  that  amount 
over  and  above  the  exemption.  Neither  is  the  tax  imposed  on  all 
income  from  certain  sources,  leaving  other  income  against  which  to 
claim  exemptions.  No  such  distinction  between  different  kinds  of 
income  is  intended  by  the  act,  yet  the  necessary  result  of  the  provisions 
for  collection  at  the  source  is  to  make  that  distinction. 

The  so-called  tax-exempt  covenant  was  in  reality  never  intended 
to  operate  under  a  personal  income  tax.  The  Civil  War  income  tax 
acts  contained  a  provision  that  certain  specified  classes  of  corporations 
should  be  subject  to  pay  a  tax  of  5  per  cent  of  the  amount  of  all  their 
interest  or  coupon  payments  to  whomsoever  payable,  with  a  proviso 
that  said  companies  were  authorized  to  deduct  and  withhold  from  all 
such  payments  the  amount  of  the  tax.  The  payment  of  the  tax  so 
deducted  discharged  the  company  from  liability  for  a  corresponding 
amount  of  interest  upon  the  obligations  referred  to,  except  where  the 
company  might  have  contracted  otherwise.  This  tax  was  held  by  the 
Supreme  Court  of  the  United  States  in  Railroad  Company  v.  Collector, 
100  U.  S.  595,  and  in  United  States  v.  Erie  Railway  Company,  106  U.  S. 
327,  to  be,  not  an  income  tax  upon  the  holders  of  the  corporate  obliga- 
tions affected,  but  an  excise  tax  upon  the  business  of  the  corporation 
in  respect  to  its  interest  payments,  the  company  being  merely  granted 
the  privilege  of  passing  this  tax  on  to  the  holders  of  its  securities. 

The  so-called  "tax-free"  clause  in  modern  corporate  obligations 
arose  from  these  provisions  of  the  Civil  War  income  tax  acts.  It  was 
designed  to  protect  the  creditor  against  the  passing  on  to  him  of  this 
type  of  tax.  In  other  words,  he  took  advantage  of  the  suggestion  in 
the  law  itself  to  demand  contracts  protecting  him  against  the  deduction 
of  this  kind  of  tax.  The  language  of  the  typical  "tax-free"  clause, 
however,  framed  at  the  instance  of  creditors  who  demanded  protection 
against  every  possible  contingency  in  the  premises,  is,  in  its  usual  form, 
so  broad  as  apparently  to  comprehend  not  only  an  excise  tax  upon 
the  business  of  the  corporation  deductible  as  against  its  security-holders, 
but  a  tax  like  the  present  income  tax  which  is  levied,  not  upon  the 
corporation,  but  upon  the  recipient  of  the  interest,  and  which  solely, 
SLS  a  means  of  collection,  the  corporation  is  required  to  withhold  and 
pay  to  the  government.  The  corporations  and  their  creditors  have 
accepted  this  construction  of  these  clauses  under  the  present  act.  The 
result  has  been  that  a  tax  which  Congress  intended  to  levy  upon  the 


FEDERAL    INCOME    TAX  849 

income-receiver  has,  in  this  case,  been  shifted  to  the  income-producer. 
It  thus  falls  not  upon  the  "swollen  fortune"  which  it  is  the  professed 
purpose  of  this  act  particularly  to  reach,  but  primarily  upon  the  cor- 
poration and,  in  some  cases,  finally  upon  the  unfortunate  "ultimate  con- 
sumer" who  was  supposed  already  to  be  more  than  sufficiently  taxed. 
The  recipient  of  income  subject  to  deduction  of  the  tax  at  the 
source  is  deprived  of  the  use  and  benefit  of  the  money  withheld  during 
the  period  of  time  between  the  date  of  withholding  and  the  date  on 
which  by  the  terms  of  the  act  the  tax  becomes  due.  He  receives  no 
evidence  of  the  payment  of  the  tax  on  which  he  can  rely  for  defense 
in  the  event  of  proceedings  instituted  against  him  by  the  Bureau  of 
Internal  Revenue.  The  danger  is  not  fanciful.  Tenants  are  withhold- 
ing agents  and  it  is  not  inconceivable  that  a  tenant  may  be  insolvent 
or  have  disappeared  when  the  time  for  payment  arrives. 

Advantages  of  Collection  at  Source 

As  opposed  to  these  shortcomings  of  the  system  of  collection  at 
source,  the  chief  argument  advanced  in  its  favor  is  that  it  insures  the 
accuracy  of  the  return  and  provides  a  control  on  the  statements  of 
individuals.  Your  Committee  does  not  desire  to  express  any  opinion 
on  the  question  as  to  whether  such  a  control  is  necessary,  nor  does  it 
desire  to  compare  the  system  of  collection  at  source,  as  practiced  in 
England  and  the  United  States,  with  the  system  of  individual  return 
as  found  in  the  German  income  taxes.  On  the  assumption,  however, 
that  such  a  control  is  desirable,  your  Committee  would  like  to  point 
out  that  the  same  purpose  may  be  achieved  by  a  system  which  is  to  a 
large  extent  free  from  the  objections  that  attach  to  collection  at  source. 
This  system,  which  has  been  called  that  of  information  at  source,  will 
be  fully  explained  in  the  next  recommendation,  and  would  in  the 
opinion  of  your  Committee  constitute  a  considerable  improvement  over 
the  existing  method. 

Information  at  the  Source 

While  the  Committee  believes  that  a  proper  system  of  information 
at  the  source  will  furnish  all  the  safeguards  needed  to  prevent  eva- 
sion, it  recognizes  that  there  is  one  class  of  incomes  with  reference 
to  which  Congress  may  desire  to  retain  the  principle  of  collection  at 
the  source,  namely,  incomes  received  by  American  citizens  residing  in 
other  countries  and  by  non-resident  aliens  to  the  extent  to  which 
they  are  taxable  under  the  act.  If  it  should  be  desired  to  continue 
to  collect  the  normal  tax  from  these  incomes  at  the  source,  it  would 
be  possible  to  make  a  provision  by  which  this  should  be  done.  It 
might,  for  instance,  be  enacted  that  the  normal  tax  of  1  per  cent  be 
withheld  and  deducted  from  fixed  and  determinable  incomes  of  whatever 
amount  received  by,  or  accruing  to,  citizens  of  the  United  States 
residing  abroad  and  taxable  non-resident  aliens,  proper  administrative 
provision  being  made  in  connection  with  the  general  scheme  of  informa- 
tion at  source  hereinafter  developed  to  establish  the  taxable  status 
of  the  recipient  of  such  income. 

Operation  of  Deduction  at  the  Source 

Under  the  present  system  of  collection  at  the  source,  the  Bureau 
of  Internal  Revenue  has  no  means  of  accurately  checking  the  returns 


850  AUDITING 

of  taxpayers  except  by  assembling  the  multitude  of  ownership  certifi- 
cates, arranging  them  under  the  names  of  the  respective  signers  and 
adding  up  the  total  of  income  reported  and  exemptions  claimed  by 
each.  Unless  this  be  done,  the  Bureau  must  rely  not  only  on  the 
honesty  of  the  taxpayer  but  on  his  intelligence  and  care  as  well.  Many 
persons  signing  ownership  certificates  keep  no  record  of  the  exemptions 
theretofore  claimed  on  other  certificates  during  the  year,  and  many 
are  uncertain  as  to  the  effect  of  claiming  exemption  on  the  certificates, 
and  others  are  careless  and  unsystematic.  Undoubtedly  excessive 
claims  for  exemption  are  frequently  made  with  no  intent  to  defraud 
the  government.  The  complicated  arrangement  of  the  annual  return 
of  individuals  makes  it  not  unlikely  that  amounts  of  income  on  which 
exemption  was  claimed  are  often  placed  in  column  A,  resulting  in  a 
further  possible  loss  to  the  government. 

The  only  means  of  guarding  against  the  potential  losses  referred 
to  in  the  preceding  paragraph  lie  in  the  diligence  with  which  the 
Bureau  of  Internal  Revenue  collects  and  assembles  the  ownership 
certificates. 

After  the  collection  and  indexing  of  the  certificates  has  been  com- 
pleted, it  is  of  little  practical  importance  whether  the  amounts  thereon 
stated  represent  merely  income  from  various  sources  or  income  from 
which  the  tax  has  been  deducted.  In  either  case  the  government  has 
the  same  definite  information  concerning  the  income  of  the  taxpayer 
and  the  same  power  to  enforce  payment  of  the  tax.  If  the  owner- 
ship certificates  indicate  the  taxable  liability  of  the  signer,  why  should 
not  the  government  proceed  by  direct  means  to  collect  the  tax  from 
the  taxpayer  instead  of  using  the  present  indirect  means  which  place 
additional  expense  upon  certain  classes  of  citizens  and  result  in  unfair 
discrimination? 

Operation  of  Information  at  the  Source 

Your  Committee  recommends  a  system  of  information  at  the  source 
which  will  require  the  recipient  of  income  to  give  the  payer  once  each 
year,  or  at  the  time  of  payment,  a  receipt  in  such  form  as  may  be 
prescribed  by  the  Treasury  Department.  Such  receipts  should  be  for- 
warded by  the  payer  to  the  local  collector  as  ownership  certificates 
now  are.  The  payer  should  be  required  to  make  oath  that  he  has 
obtained  and  filed  receipts  for  all  payments  of  income  of  the  kinds 
enumerated  in  the  act.  Penalties  should  be  prescribed  for  attempts  to 
evade  the  law  or  the  obligations  placed  by  it  upon  payers  and  recipients 
of  income.  Your  Committee  further  urges  that  a  reasonable  com- 
pensation be  paid  to  the  payer  of  income,  based  upon  the  number  of 
receipts  filed  with  the  government,  to  compensate  him  for  the  expense 
incurred. 

A  practical  working  out  of  this  system  would  result  in  receipts 
used  by  individuals  and  corporations  receiving  many  payments  in  the 
course  of  the  year,  having  the  name  of  the  recipient  printed  thereon 
primarily  for  the  convenience  of  the  government  in  aiding  it  to  de- 
cipher signatures.  The  signature  on  the  receipt  being  merely  for  the 
purpose  of  authentication,  the  printed  names  only  need  be  consulted 
in  assembling  the  certificates. 

To  put  our  suggestions  more  in  detail,  your  Committee  recom- 
mends that  all  persons,  firms,  corporations,  etc.,  who  pay  to  any  other 
person  subject  to  taxation   under  the  act  amounts  of  fixed  and  de- 


FEDERAL    INCOME    TAX 


851 


terminable  income,  other  than  interest  upon  bonds  and  other  obliga- 
tions of  corporations,  joint-stock  companies,  and  associations,  in  excess 
of  the  amount  of  $800  per  annum,  shall,  on  or  before  the  first  day  of 
March  in  every  calendar  year,  report  to  the  collector  of  internal  revenue 
of  the  district  in  which  they  reside  the  amount  of  all  such  income  paid. 

In  the  case  of  interest  paid  upon  bonds  or  other  obligations  of  cor- 
porations, joint-stock  companies,  or  associations,  information  can  be 
secured  of  all  payments  by  requiring  the  corporation  or  its  fiscal  agent 
to  report,  on  or  before  the  first  day  of  March  in  each  calendar  year, 
the  amount  of  such  payments,  whether  they  exceed  $800  or  not. 

To  provide  for  the  case  of  coupon  bonds,  it  should  then  be  provided 
that  no  corporation  or  its  fiscal  agent  should  pay  any  interest  coupon 
unless  it  is  accompanied  by  a  certificate  containing  the  name  of  the 
owner ;  and  then  providing  that  no  person,  company,  or  corporation 
shall  buy  or  accept  for  collection  or  deposit  any  such  coupon  without 
requiring  the  holder  to  file  a  certificate  stating  that  he  is  the  owner, 
and  giving  his  address.  The  person,  company,  or  corporation  buying 
or  accepting  for  deposit  should  be  required  to  certify  to  the  signature 
of  the  signer  of  the  certificate,  but  not,  of  course,  to  the  fact  of  owner- 
ship of  the  bond.  Under  this  arrangement  no  person  could  cash  or 
deposit  a  coupon  without  filing  a  certificate  stating  that  he  was  the 
owner  of  the  bond,  and  the  person  buying  the  coupon  or  taking  it 
for  collection  would  have  to  certify  to  the  identity  of  the  person  who 
claimed  to  own  the  bond.  The  corporation  or  its  fiscal  agent  would 
in  this  way  be  provided  with  evidence  about  the  ownership  of  coupon 
bonds,  and  could  by  a  card  index  keep  track  of  bondholders.  The 
government  would  obtain  its  information  once  a  year  in  convenient 
form,  and  after  the  first  year  changes  in  ownership  only  would  need 
to  be  noted. 

Under  this  plan  of  information  at  the  source,  no  questions  need 
ever  arise  as  to  whethep  a  person  was  liable  to  tax  or  entitled  to  ex- 
emptions or  abatements,  because  the  person  paying  the  income  could 
in  all  cases  file  his  certificate  and  let  the  government  deal  with  the 
question  of  liability.  Since  no  money  is  to  be  withheld  and  deducted 
and  accounted  for,  the  problem  will  be  enormously  simplified. 

The  objection  is  sometimes  made  that  to  collect  the  tax  from  the 
bondholder  will  impair  the  obligation  of  contracts  made  between  cor- 
porations and  their  bondholders.  The  Committee  attaches  no  weight 
to  this  objection.  As  is  pointed  out  above,  the  so-called  tax-exempt 
covenant  was  never  intended  to  operate  under  a  law  taxing  personal 
income  as  such.  But  entirely  apart  from  this  consideration,  it  must 
be  remembered  that  no  one  claims  that  it  is  a  violation  of  the  contract 
to  collect  from  the  bondholder  the  additional  tax,  which  may  amount 
to  6  per  cent,  and  that  the  law  does  this  without  any  question.  How, 
then,  can  it  be  claimed  that  it  is  a  violation  of  contract  to  collect  the 
normal  tax  from  the  bondholder? 

In  his  annual  report,  dated  December  6,  1915,  the  Secretary  of  the 
Treasury  said: 

I  am  of  the  opinion  that  it  would  be  very  advantageous  to  have 
this  law  amended  so  as  to  do  away  with  the  withholding  of  the  income 
tax  at  the  source,  and  in  place  thereof  to  require  information  at  the 
source;  that  it  will  mean  the  collection  of  a  larger  amount  of  revenue 


852 


AUDITING 


and  eliminate  a  great  deal  of  criticism  which  has  been  directed  against 
the  law.  If  such  an  amendment  is  adopted,  an  exception  should  be 
made  in  the  case  of  non-resident  aliens,  whose  tax  would  necessarily 
be  withheld  at  the  source. 

It  is  gratifying  to  note  that  the  Treasury  Department  thus  goes  on 
record  as  favoring  an  amendment  to  the  law  along  the  lines  suggested 
by  the  National  Tax  Association. 


FEDERAL  INCOME  TAX 
INDEX 


Accident  benefit  associations, 

exempt  from  income  tax,  820 
Accident  insurance    (See  "Insur- 
ance, Accident") 
Accounting,     good     practice     de- 
mands reserves  against  losses, 
800 
Agricultural  associations,   exempt 

from  tax,  820 
Agricultural  corporations, 

donations  by,  to  fairs,  835 
Aliens,  non-resident, 

dividends    on    corporate    stock, 

814 
fiduciaries  reporting  for,  815 
income  of,  814 
interest  on  bonds,  814 
report  on  form  1040  revised,  815 
Annuities, 
gifts,  782 

life  insurance,  782 
Appreciation,  capital  assets,  827 
Assessment     districts      (improve- 
ments)   (See   "Political   Sub- 
divisions") 
Assets,  capital, 

appreciation  of,  827 
Associations  (See  also  "Clubs") 
commercial  men's,  not  exempt, 

821 
dividends,  786 
exempt  from  tax,  820 

interest   on   bonds   to   be   ac- 
counted for  by  holder,  821 
fraternal    benefit   exempt    from 
tax,  820 

853 


B 

Bad  debts  (See  "Debts") 
Baldwin  Locomotive  Works, 
valuation  increased  by  appraisal, 
829 
Banks, 
bank  stock  taxes  paid,  795 
mutual  savings,  capital  stock  not 
represented  by  shares,  820 
Beneficiary,  returns  by,  816 
Board   furnished  employees   free, 

treated  as  income,  774 
Boards  of  trade,  exempt  from  in- 
come tax,  820 
Bonds, 
American  corporations, 

foreign    holders    not    taxable 
for  interest,  161 
coupon,     and     information     at 

source,  851 
discount  on, 
as  losses,  839 
method  of  handling,  839 
exempt  organizations, 

interest  to  be  accounted   for 
by  holder,  821 
exemption  certificates  affect  re- 
turns, 843 
fidelity;  premium  on,  791 
foreign,  interest  on,  845 
losses  in  purchase  and  sale,  801 
premium  on,  839 
retirement,  losses  by,  840 
tax  free,  794,  845 
abuse  of,  by  individual,  847 
income  returnable,  826 
rrovisions  in,  843 


854 


INCOME    TAX     INDEX 


Bonds — continued 
worthless,  charged  off  as  debts, 
801 
Bonuses  to  employees,  834 
Buildirg    and    loan    associations, 
domestic,     exempt    from    in- 
come tax,  820 
"Business,"  definition,  798 
Business  leagues,  exempt  from  in- 
come tax,  820 


Campaign    contributions    not    ex- 
pense, 833 
Capital  stock, 
paid  up,  defined,  841 
preferred, 

dividends  not  deductible,  841 
not  a  liability,  840 
proceeds  of  sale,  825 
subscriptions,    proceeds   of   sale 
of  rights,  786 
Cemetery  companies, 

exempt  from  income  tax,  820 
Chamber  of  Commerce, 
exempt  from  income  tax,  820 
State  of  New  York ;  income  tax 
for  State  favored  by,  760 
Charitable  associations, 
exempt  from  income  tax,  820 
gifts  of  merchandise  to,  836 
Cities  (See  "Municipalities") 
Civil  War  income  tax,  348 
Clergymen, 
English,   rent    of    study  under 

British  income  tax  act,  792 
fees  received,  776 
gifts,  Christmas,  776 
parsonage  rent  free,  774 
Clubs  (See  also  "Associations") 
exempt    organizations,    require- 
ments to  register  as,  822 
social,     exempt     organizations, 
822 


Collateral, 
as  contemplated  by  act,  837 
indebtedness  secured  by ;  inter- 
est on,  836 
real  estate  as,  837 
the  subject  of  sale,  defined,  838 
Collection  at  source, 
advantages  of,  849 
and  financial  institutions,  846 
and  information  at  source,  851 
cost  of,  846 

excessive,  845 
objections  to,  846 
operation  of,  849 
suggested  modification,  845 
unjust  discrimination,  847 
Columbia,  District  of, 
public   utilities    owned   and   op- 
erated by  government  exempt 
from  income  tax,  820 
Commercial  men's  associations, 
exemption    from   tax    does    not 
apply,  821 
Commissions, 
executors';    chargeable   to   cor- 
pus of  estate,  816 
paid  in  stock,  835 
real  estate  agents',  791 
salesmen's,  792,  835 
Companies,  joint-stock, 

dividends,  786 
Compensation  based  on  stock  hold- 
ings, 835 
Compensation,   special;   when  de- 
ductible,  835 
Connecticut    Mutual    Life    Insur- 
ance Co.  V.  Eaton,  833 
Consumer,  effect  of  tax  on,  849 
Contract,  employment ;  affects  tax- 
able items,  776 
Contracting  companies, 
income     based     on     completed 
work,  828 


INCOME    TAX    INDEX 


855 


Corporations    (See   also   "Indivi- 
duals") 

accounts  payable,  treatment  of, 
832 

agricultural, 
donations  to  fairs,  etc,  835 

appreciation    of    capital    assets, 
827 

associations   and,   exempt   from 
tax,  820 

bonds    held    by    foreigners,    in- 
terest on,  767 

bonds,  tax  free,  794,  826,  843 

books   must  confirm   figures   of 
annual  returns,  818 

capital  stock,  proceeds  of  sale, 
825 

collection  at  source  unfair  ex- 
pense upon,  847 

deductions    allowed,    831     (See 
also  "Deductions") 

defined,  818 

discrimination  against,  842,  847 

dividends   received  upon  stock, 
830 

domestic,  dividends,  786 

donations,  835,  836 

exempt  from  income  tax,  820 

expenses,  832 
paid  within  year,  769 
scheduling,  844 

fiscal  year,  822 

forms  specified  for  returns,  818 

income  accruing,  821 

income  returns  and  books  should 
agree,  769 

income,  taxation  of,  768 

interest  on   indebtedness,   768 

interest,     two     classes     figured 
separately,  838 

inventory  to  determine  gross  in- 
come or  expenses,  825 

losses  actually  sustained  within 
year,  769 


obligations    imposed    upon,    817 

officers'  salaries,  834 

operating  mines  on  royalty  basis, 

809 
penalty    for    failure   to   file   re- 
turns, 818 
profit,  net  for  year,  769 
public  utility, 

income     tax     returns     should 
conform  to  Interstate  Com- 
merce Commission  rules  of 
accounting,  770 
rental  value  of  property  owned, 

834 
subsidiary, 
dividends,  825 
returns  of,  818 
supplementary  statement  for,  843 
surplus    distributed    in    liquida- 
tion, 788 
taxes  paid  within  year,  769 
wrongfully  burdened  with  col- 
lection expenses,  847 
Costumes,  theatrical, 
depreciation  on,  808 
County    employees    exempt    from 

tax,  773 
Customs  duties,  794 


Debts,  bad, 
past-due       items       ascertained 
worthless    and    charged    off, 
800 
rents,  unpaid,  800 
salaries  os  wages,  when  permis- 
sible to  treat  as,  HZ 
salaries,   unpaid,  800 
wages,  unpaid,  800 
Debts  forgiven  constitute  income, 

830 
Decisions    (See   "Treasury   Deci- 


sions") 


856 


INCOME    TAX    INDEX 


Deduction    at    source    of    income 
(See      also      "Collection      at 
Source") 
method  of,  844 
operation  of,  849 
Deductions,  789,  831 

method  of  scheduling,  843 
Depletion     (See    also    "Deprecia- 
tion"), 
allowance  for,  mines,  oil  wells, 

808 
franchises,  785 
mines,  785,  808 

National    Tax    Association    re- 
port, 810 
oil  wells,  785,  808,  810 
patents,  785 
timber  lands,  807 
Depreciation,  801    (See  also  "De- 
pletion") 
books,  must  appear  on,  803 
costumes,  theatrical,  808 
good-will,  807 

National    Tax    Association    re- 
port, 810 
•  obsolescence,  802 
patents,  807 
physician's,   808 
rates  of,  806 
inspectors,    harmful    criticism 
by,  769 
reserves,  805 
timber  lands,  807 
Wisconsin  law  on,  802 
Differentiation  of  income  tax, 
funded  and  unfunded,  767 
state    and    local    taxes    compli- 
cate, 767 
Discount,  bond, 
as  losses,  839 
method  of  handling,  839 
Discrimination, 

individual  required  to  report  for 
calendar  year,  111 


real  estate  dealers  affected,  711 

securities,   brokers   and   dealers 
affected,  171 
Dividends, 

cash,  787 

compensation  on  stock  holdings, 
835 

exempt   from  normal  tax,   786, 
845 

Exempt  from  tax  up  to  $20,000 
per  annum,  772 

from  other  corporations,  825 

life  insurance,  782,  787 

not  interest,  840 

scrip,    cash    value    questionable, 
787 

stock,  787 

subsidiary  corporation,  825 
Doctors,    deductions    allowed    in 

making  returns,  791 
Doctrine,  income,  765 
Donations  (See  also  "Gifts") 

by  agricultural  corporations,  835 

for  welfare   of   employees,   836 

to  charitable  or  educational  in- 
stitutions, or  hospitals, 
deductible  as  corporation  ex- 
pense, 836 
Duties,  794 

import,  not  deductible,  843 


Educational  associations, 
exempt  from  income  tax,  820 

Educational  institutions,  donations 
to  for  employees,  836 

Employees, 
bonuses  to,  834 
compensation  to,  834,  835 
contract,    employment   affects 

taxable  item,  lid,  834 
gifts  to,  834 
gratuities  to,  834 


I 


INCOME    TAX    INDEX 


857 


Employees — continued 
pensions  to  ex-employees,  833 
premium  on  fidelity  bond  paid 

by  them,  791 
profit-sharing    items    deductible 

if  contract  exists  with,  834 
salaries  paid,  834 
state,   county,    municipal;    com- 
pensation exempt,  773 
welfare  donations,  836 
Endowment, 
income  from,  defined,  782 
life  insurance,  782 
England, 
income   tax,    diflferentiation   of, 
767 
Erroneous  taxes,  812 
remedy  at  law,  812 
Estate, 
administration    expenses,    816 
trust,  undistributed  income,  816 
Excessive    capitalization,    induce- 
ment for,  842 
Exempt, 
dividends,  786 

dividends  on  life  insurance  en- 
dowment policies,  782 
dividends  up  to  $20,000  per  an- 
num, 772 
interest, 
bonds  of   American  corpora- 
tions exempt  from  taxation, 
767 
on  obligations  of  public  dis- 
tricts, 783 
public     utilities,     municipally 
owned,  782 
state,     county,     municipal     em- 
ployees, 773 
Exemptions, 
lower,   recommended  by   Presi- 
dent Wilson,  763 
Expenses, 
campaign  contributions,  833 


classification  of,  843 
improvements,  833 
lobbying,  833 
repairs,  incidental,  833 


Farm,  definition,  779 
Farmers, 
"gentlemen,"   operating   for 

pleasure,   780 
income  of,  defined,  779 
items  purchased  and  resold,  779 
live  stock,  780 
mutual  fire  insurance  companies, 

821 
tools,  ordinary,  780 
Federal  income  tax  (See  "Income 

Tax,   Federal") 
Fees,  compensation  in,  method  of 

returns,  776 
Fiduciaries,  815 
annual  returns  by,  815 
deductions  not  allowed,  816 
guardians   of   one   ward   report 

on  form  1040  revised,  815 
incompetents,  acting  for,  817 
minors,  acting  for,  817 
report  on  form  1041  revised,  815 
Financial  institutions,  and  collec- 
tion at  source,  846 
Fiscal  year, 
individual  must  report  on  cal- 
endar year,  777 
individual  partner  can  report  on 

partnership  fiscal  year,  777 
of  corporations, 

income   tax   returns   covering 
fiscal    instead    of     calendar 
year,    requirements    to    file, 
822 
new  organizations,  822 
Foreigners   (See  aliens,  non-resi- 
dent, 814) 


858 


INCOME    TAX    INDEX 


Forms, 
fiduciaries  report  on  form  1041 

revised,  815 
fiduciary  reporting  as  guardian 

uses  form  1040  revised,  815 
individual  (form  1040  revised), 

m 

overpayment  of  tax  (form  46), 
811 

adjustment     (form    1008    re- 
vised), 811 
Fuel  furnished  free  to  employees, 
774 

G 

Gifts  (See  also  "Donations") 
Christmas,  to  clergymen,  776 
of  merchandise,  836 
property  acquired  by, 
gains,  profits,  or  income,  785 
value,  785 
to  corporations,  830 
to  employees,  834 
to  individuals,  830 
Good-will,   depreciation  of,  807 
Government,  support  of, 
individual  subjects  should  con- 
tribute, 760 
Gratuities   to   employees,   834 
Great  Britain,  income  tax,  759 
Gross  income    (See  "Income, 

Gross") 
Guardian,   fiduciary   reporting  as, 
815 

H 

Heat,  fuel,  etc., 

furnished  free,  774 
Horticultural    associations, 

exempt  from  tax,  820 
Hospitals,  donations  to,  836 
Hull,  Cordell   (Congressman), 

federal  income  tax,  763 

opinion    on     securities,    deduc- 
tions allowable,  796 


I 

Illegal  taxes,  812 

remedy  at  law,  812 
Import  taxes  (See  "Duties") 
Improvements       providing       for 

growth  of  business,  833 
Income, 
corporate,  taxation  of,  768 
debts  forgiven  treated  as,  830 
deduction  at  source  of,  844 
dividends  exempt  up  to  $20,000 

per  annum,  772 
doctrine  of,  765 
double  taxation  of,  766 
equivalents,  rent,  774 
farmers',  779 
crop  shares,  rents,  780 
deductions  not  allowed,  780 
gifts  to  corporations  considered 

as,  830 
gross, 
accident  insurance  policy  re- 
ceipts, 786 
deductions   allowed,  824 
deductions    from    salaries    or 

wages,  773 
dividends  received  upon  stock 
not  deductible  by  corpora- 
tions, 330 
interest  included,  825 
rent  equivalent  to   employees 

not  deductible,  774 
rentals  included,  825 
royalties  included,  825 
salaries  and  wages,  773 
source  of, 

deduction  at,  844 
information  at,  849 
tax   (See  below) 
undistributed,  trust  estates,  816 
valuation  increased  by  appraisal 
is  not,  829 
Income  tax,  federal, 
authority  on,  764 


INCOME    TAX    INDEX 


859 


Income  tax,  federal — continued 
complexity  of  present  law,  764 
defects  in,  763 
differentiation  of,  767 
England;     earned     and     un- 
earned, 767 
Italy;  property,  business,  and 

labor  incomes,  767 
United    States;     funded    and 
unfunded,  767 
erroneous  taxes,  812 
illegal  taxes,  812 
law, 
administration,  competent,  762 
efficient  administration  essen- 
tial, 769 
legislation  in  United  States,  762, 

763 
objections  to, 
inquisitorial  features,  760 
revealing      information      un- 
founded, 761 
on  all  earnings  and  receipts  in 

U.  S.,  766 
overpayment  of,  811 
states,  application  to,  761 
Incompetents,     fiduciaries     acting 

for,  817 
Increment,  unearned, 

depreciation  not  based  on,  808 
Indebtedness, 
maximum     interest     deductible, 

842 
secured    by    collateral,    interest 
on,  836 
Individuals, 
assessments  against  local  bene- 
fits, 794,  795 
bonds,   losses    in   purchase   and 

sale  of,  801 
bonds,    worthless,    charged    off 

as  debts,  801 
calendar    year    report    required 
from,  777 


commissions  paid,  791,  792 
custom  duties  as  cost  of  goods, 

794 
custom  duties  as  tax,  794 
debts,  bad,  800 

deductions   (See  "Deductions") 
depreciation,  801 
dues     and     expenses,     business 

clubs   and  associations,   790 
exempt;  dividends  up  to  $20,000 

per  annum,  772 
exemption,  813 
expenses  actually  paid,  769 
expenses  in  earning  income  not 

subject  to  tax,  790 
expenses,   personal,    living,   and 

family,  789 
gifts  to,  830 
income,  net,  defined,  771 
income  statement  should  be  an- 
alyzed by,  772 
income  tax  withheld  at  source 

or  paid  to  collector,  795 
interest,  793 

paid  within  year,  769 
losses  actually  sustained  within 

year,  769 
merchandise  cost,  789 
obligations  imposed  upon, 

return    on    income   exceeding 
$3,000,  771 

withhold  at  source,  771 
partnership    business    expenses, 

789 
premium  on  fidelity  bonds,  791 
professional  men,  791 
property,  improvements  or  bet- 
terments, 789 
railroad  fares,  790 
replacements,  cost,  802 
salaries    or    wages    uncollected, 

treatment  of,  773 
securities  purchased  or  sold,  795 
stocks,  801 


86o 


INCOME    TAX    INDEX 


Individuals — continued 
taxes,  794 
assessed  on  bank  stock,  795 
paid  for  landlord,  792 
paid   foreign  countries,  794 
paid  on  "tax  free"  bonds,  794 
paid  within  year,  769 
Information  at  source,  849 
and  collection  at  source,  850 
operation  of,  851 
Inspectors*  decisions,  possible  in- 
accuracy of,  771 
Instalment  payments, 
real  estate, 
default  less  salvage  on  prop- 
erty     repossessed      portion 
chargeable  to  bad  debts,  781 
Insurance, 
accident, 
death  beneficiaries   (See  "In- 
surance, Life") 
receipts  from  policy,  786 
companies,     dividends     exempt, 

786 
fire,  premiums,  treatment  of,  792 
fraternal  benefit,   exempt   from 

income  tax,  820 
life, 
annuities,  782 

dividends,     accrued     or     re- 
ceived, 782 
dividends    paid   but   not    ma- 
tured, 787 
dividends,     paid-up     policies, 

787 
partner,    death   of;   insurance 
in  favor  of  partnership,  792 
premiums,   792 
premiums      on     partner's      life 
insurance  in  favor  of  part- 
nership, 792 
premiums    paid    by    corpora- 
tion, 832 
proceeds  received  by  corpora- 


tion, 832 

mutual     companies,     exemption 
not  applicable  to,  821 
Interest, 

as  rental  charge,  841 

bonds  of  American  corporations 
in  foreign  hands,  767 

bonds  of  exempt  organizations, 
821 

corporations   limited   as   to   de- 
ductions,  768 

deduction  at  source,  845 

deductions  allowed,  793 

deductions  limited,  840 

earnings  report,  regardless  of 
source,  781 

exempt,  782 

government  obligations,  785 

manufacturing  cost,  833 

method  of  stating,  838 

not  dividends,  840 

on  indebtedness, 
maximum  deductible,  842 
secured  by  collateral,  836 
secured  by  trust  mortage, 
837 

real  estate, 

deduct  yearly,  781 
investors  in,  780 
not  allowed  if  added  to  book 
value,  781 
Internal    Revenue,    Commissioner 
of,  recommended, 

foreign   taxes    be    made   allow- 
able deductions,  794 

income  from  dividends  to  be  in- 
cluded in  returns,  772 

partnerships     report     on     same 
basis  as  corporations,  785 

returns  on  all  incomes  $3,000  or 
over,  773 
Internal    Revenue,    Deputy   Com- 
missioner, 

proceeds  of  sale  of  rights,  786 


INCOME    TAX    INDEX 


86 1 


Interstate  Commerce  Commission, 
corporation   income   tax   report 
should    conform    to    balance 
sheet  required  by,  770 
Inventory, 
equivalent,  defined,  825 
physical    or    equivalent,    to    de- 
termine gross  income  or  ex- 
penses, 825 
recommended  to  determine  gains 
or  losses,  778 
Investor,  real  estate,  780 
Italy,   income  tax,   differentiation 
of,  767 

J 

Joint-stock  companies,  786 


Labor,  included  in  cost  of  manu- 
facture, 833 

Labor,  unproductive, 
supervision  cost,  833 

Labor  associations, 
exempt  from  tax,  820 

Lawton,  William  H.,  on  deprecia- 
tion reserves,  handling  of, 
805 

Lawyers,  deductions  allowed  in 
making  returns,  791 

Legislation,  762,  763 

Lessee, 
royalty  basis,   operating  mines, 
oil  wells,  etc.,  785 

Life  insurance  (See  "Insurance, 
Life") 

Light  furnished  employees  free, 
774 

Liquidation,  mandatory,  of  cor- 
poration, 788 

Loan  associations  (See  "Build- 
ing and  Loan  Associations") 

Lobbying  expenses,  833 

Lodges,  fraternities  exempt  from 
tax,  820 


Lodging  furnished  employees  free, 

774 
Losses,  795,  839 
bond  discount,  839 
bond  retirement,  840 
fire,  795 

on  securities,  799 
real  estate,  treatment  of,  778 
reserve  for,  800 
shipwreck,  795 

stockbrokers',  treatment  of,  778 
trade,  795,  798 
Lumber  companies,  deduction  for 
return    of    capital    assets    al- 
lowed by  court,  828 
M 
McAdoo,    W.    G.    (Secretary    of 
Treasury), 
losses,  opinion  on  law,  798 
Management  expenses,  792 
Manufactured   products,    cost   of, 

833 
Manufacturing   costs, 
interest  deductible,  833 

interest  not  deductible,  834 
rental  value  not  deductible,  834 
May  V.  Sloan,  "trade"  defined,  797 
Mayor's  Committee  on  Taxation, 
income  tax  for  state  favored 
by,  760 
Merchandise,  gifts  of,  836 
Merchants'  Association  of  N.  Y. 
City, 
income  tax  for  state  favored  by, 
760 
Michell  Bros.  Co.  v.  U.  S.  Inter- 
nal Revenue  Collector,  828 
Mines, 
gross  value  at,  809 
income  defined,  785 
leased,  base  depletion  on  cost  of 

lease,  809 
royalty  basis  of  operation  pre- 
cludes depreciation  claim,  809 


862 


INCOME    TAX    INDEX 


Minors,  fiduciaries  acting  for,  817 
Municipal  employees  exempt  from 

tax,  773 
Municipalities, 
income  tax,  adoption  by,  760 
income  tax,  application  to,  761 

N 
National  Tax  Association, 
authority  on  income  tax,  764 
discrepancies   between  law   and 
modern    accounting    practice, 
769 
on   allowances    to    corporations 

and  individuals,  796 
on  collection  at  source,  845 
.    on  deductions  of   dividends  by 
corporations,  831 
on     depletion     of     natural     re- 
sources, 810 
.  on  depreciation  of  property,  810 
on  gains   or   losses   determined 

by  annual  inventory,  778 
on  individual  exemption,  813 
on    management    expenses,    792 
on  refund  of  income  tax,  813 
on   subsidiary   corporations    re- 
ports, 819 
on  taxes  paid  foreign  countries, 
794 
Natural    resources     (See    Mines, 

Oil  Wells,   Timber  Lands) 
Nebraska  Special  Commission  on 
Revenue  and  Taxation, 
objection  to  revealing  informa- 
tion unfounded,  761 
New  York,  State  of, 
income  tax  law  proposed,  760 

O 

Obsolescence     ( See    depreciation, 

802) 
Officers,  United  States  Army, 
heat,      light,      etc.,      allowances 

equivalent  to  income,  774 


Overhead,   included   in   cost   of 

manufacture,  833 
Overpayment  of  tax,  811 


Paid-up  capital  stock,  defined,  841 
Parsonages,    rent    equivalent    re- 
turnable as  income,  774 
Partnerships, 
gains  and  profits,  distributed  or 
not,  individual  returns  to  in- 
clude, 783 
income    returns    and    books    of 

account  should  agree,  769 
interest  on  government  obliga- 
tions, 785 
limited,  are  corporations  under 
federal   income  tax   law,   818 
profit,  net  for  year,  769 
profits  and  list  of  partners  en- 
titled to  same  to  be  furnished 
Commissioner      of      Internal 
Revenue  on  demand,  783 
returns  can  be  for  fiscal  or  cal- 
endar year  by  individual  part- 
ner, 783 
Patents,  depreciation  of,  807 
Pensions,  employees',  833 
Physician,     depreciation     claimed 

by,  808 
Political  subdivisions  defined,  782 
Preferred  stock,  not  liability,  840 
Premium, 
bond,  839 
insurance,  792,  832 
Professions,  776 
cash  book,  form  suggested,  Tl(i 
clergymen,   rent  allowed,   774 
compensation  in  fees  returnable 
year  of  receipt,  776 
Profit,    instalment    payments    in- 
cluded as  earnings  in  real  es- 
tate, 781 


INCOME    TAX    INDEX 


863 


Profit-sharing  expense,  deductible 
if    contract    with    employees 
exist,  834 
Proprietor,   sole    (See   "Individu- 
als") 
Prorating  profits   on   real   estate, 

781 
Protest,  payment  under, 
disputed  items,  797 
tax  on  dividends  if  assessed,  785 
tax  on  interest  on  government 
obligations  if  assessed,  785 
Public  utilities, 
exempt  from  income  tax  when 
owned  and  operated  by  gov- 
ernment, 820 
interest  and  rental,  839 
Public  Utility  Commissions,   uni- 
form accounts  of,  as  basis  for 
returns,  770 

R 

Railroad  Co.  v.  Collector,  848 
Railway    companies,    schedule    of 

deductions  for,  844 
Rates, 
depreciation     (See     "Deprecia- 
tion") 
exemption,     changes     proposed 
by  Secretary  of  Treasury,  814 
Raw  material  included  in  cost  of 

manufacture,  833 
Real  estate, 
agents'  commissions,  791 
carrying  charges  can  be  added 

to  initial  cost,  829 
dealer, 
interest  on  secured  indebted- 
ness, 837 
losses,  778 

losses  deductible  if  incurred, 
780 
interest, 
deduct  yearly,  781 


earnings    reported    regardless 
of  source,  781 
investor,    losses   cannot   be   de- 
ducted by,  780 
pledge  for  payment,  836 
profit,    instalment   payments   do 
not  affect  inclusion  of  profit, 
781 
prorating  of  profits,  781 
rent  accounts  receivable,  meth- 
od of  reporting,  781 
rental,  838 
Savings  Bank  v.  United  States, 

813 
taxable  profits,  781 
transactions,   income   from,  828 
Receivable  accounts, 
report   as   income,   even   if   not 
collected,  826 
Religious      associations      exempt 

from  income  tax,  820 
ReHgious   organizations,  gifts   to, 

of  merchandise,  836 
Rent, 
clergyman's      study,      deducted 
under  British  income  tax  act, 
792 
income,  equivalent  of,  774 
interest  on  real  estate  as  rental 

charge,  838 
real  estate, 

accounts    receivable,    method 
of  reporting,  781 
value    in    manufacturing    cost, 
834 
Repairs,  incidental,  833 
Replacements,  cost  of,  802 
Reserves, 
depreciation,  805 
for  taxes,  843 

inspectors,      harmful     criticism 
by,  769 
Retirement   of   bonds,    losses   by, 
840 


864 


INCOME    TAX    INDEX 


Returns, 

checking  of,  849 

forms  of  (See  "Forms") 
Royalties,   mines,    oil    wells,  pat- 
ents, franchises,  785 


Salaries,  834 

uncollected,    treatment    of,    773 
Salesman,    commissions    to,    paid 

in  stock,  835 
Scientific   associations, 

exempt  from  income  tax,  820 
Scrip      dividends      (See      "Divi- 
dends") 
Securities, 

accounting  method  suggested 
for  partnerships  dealing  in, 
799 

deductions  allowed,  795 

losses  on,  799 
dealers',  778 

shrinkage  in  values,  800 
Seligman,  Edwin  R.  A.    (Prof.), 

income  tax  development,  759 
Sick  benefit  associations, 

exempt  from  income  tax,  820 
Smith,  Adam, 

"Wealth  of  Nations,"  760 
Societies    (See   "Associations") 
Source  of  income, 

deductions  at,  844 

information  at,  849 
Speer,    L.    F.    (Deputy    Commis- 
sioner), 

decisions  by,  786,  795 
State  employees  exempt  from  tax, 

m 

Statement,  supplementary,  for  cor- 
porations, 843 

States, 
income   tax,   adoption   of,   760, 
761 


New    York    State    law    prob- 
able, 760 
Wisconsin  income  tax  law,  760 
Stock, 
capital  paid  up,  defined,  841 
deduction  not  allowed  as  it  is 

not  debt,  80i 
dividends,   taxable   income,   787 
live,  breeding;  treated  as  capi- 
tal invested,  780 
paid  as  commission,  835 
preferred,  not  liability,  840 
Stockholders,  bank, 
taxes  assessed  deductible  by  in- 
dividual stockholder,  795 
Stockholdings,  compensation  based 

on,  835 
Subsidiary      corporations       (See 

"Corporations") 
Supertax     higher,     recommended 

by  President  Wilson,  763 
Surplus     liquidating     corporation 
surplus  taxable  as  dividends, 
788 


Tax,    federal    income    (See    "In- 
come Tax,  Federal") 
Taxation, 

corporate  incomes,  768 

double,  766 
dividends  of  corporations,  831 
Taxes,  843 

assessed   against   local   benefits, 
794,  795 

bonds,  tax  paid  on  tax-free,  de- 
ductible by  individual,  794 

for  local  benefits,  843 

foreign  country,  paid  to,  794 

import   (See  "Duties") 

national,    state,    county,    school 
and  municipal,  794 

paid  by  tenant  for  landlord,  792 

reserves  for,  843 


INCOME    TAX    INDEX 


865 


Tax-free  bonds  (See  "Bonds") 
Teachers,  public  school, 
exempt   from  tax,  unless  com- 
pensation  is   paid   by   United 
States,  773 
Tenants,    as    withholding    agents, 

849 
Textile,      depreciation'     on      mill 

working  double  shifts,  803 
Theatrical  costumes,   depreciation 

on,  808 
Timber  lands,  depreciation  of,  807 
"Trade,"  definition  of,  797 
Treasury  decisions, 
aliens,  non-resident   (2090),  815 
compensation    in    fees,    making 

returns  (2090),  776 
corporations  liable  to  make  re- 
turns (2152),  820 
deductions,  method  of  schedul- 
ing (1031),  843 
dividends  received  by  corpora- 
tions (2137),  830 
donations    by   agricultural    cor- 
porations  (2090),  835 
donations    for   welfare    of   em- 
ployees (2090),  836 
estate,  administration  of  (2090), 

816 
fallibility  of,  793 
fiduciaries  (2090),  815 
fiduciaries    acting    for    minors 
and  incompetents   (2231),  817 
fiscal  year,   corporations    (2090, 

2137),  822,  823 
gifts,  gratuities,  bonuses  to  em- 
ployees (2090),  834 
insurance,  life  (2090),  832 

policies   (2090),  832 
"in    trade,"    definition     (2005), 

798 
interest,  non-taxable  (2090),  782 
interest  on  indebtedness  secured 
by  collateral  (2090),  838 


interest,  two  classes  (1993),  838 

losses  (1989),  798 

losses   must  be  absolute   to  be 

deductible   (2005),  778 
method     of      stating      interest 

(1993),  838 
overhead  charges,  833 
partners'     distributive     interest, 

1914  (2137),  783 
political     subdivisions      (1946), 

783 
premium     on     fidelity      bonds 

(2090),  791 
real  estate  (2090),  781 
real  estate  agents'  commissions 

(2090),  791 
real  estate,  taxable  profits,  781 
rent  equivalent  (2090),  774 
stock  dividends  (2274),  787 
status   as   dealer,   manufacturer 
or  trader  must  be  established 
to  claim  losses  (2090),  798 
surplus    distributed    in    liquida- 
tion taxable  (2163),  788 
taxes   (2090),  792 
taxes     paid     foreign     countries 

(2090),  794 
U.  S.  army  officers   (2079),  774 
wages  or  salaries  (2224),  ITh 
Treasury,      Secretary      of      (See 

"United  States  Treasury") 
Trustee,    compensation    for    serv- 
ices, treatment  of,  774 


U 


United  States  army  officers   (See 

"Officers,  U.  S.  Army") 
United  States  Treasury,  Secretary 

of, 
citations    from    annual    report, 
770,  851 
U.  S.  V.  Erie  Railway  Co.,  848 


g56  INCOME    TAX    INDEX 

V  W 

Valuation,  Wages    (See  "Salaries'") 

real  estate,  annual  valuation  of,  Wisconsin, 

779  depreciation,  law  on,  802 

Vocations  (See  professions,  776)  income  tax  law,  760 


GENERAL  INDEX 

(For  federal  income  tax,  sec  special  index  in  income  tax  section, 
page  853  et  seq.) 


Acceptances,  175 

Accident  and  health  insurance,  584 
Accommodation  indorsements,  170 
Accountants,  fees,  35 
Accounting, 
as  a  qualification  for  an  audi- 
tor, 3 
distinguished  from  auditing,  1 
Accounts, 
bad  or  doubtful,  371 
branch,  376 

classes  of,  in  auditing,  530,  531 
classification,      public      utilities, 

632 
controlling,  301,  303 
capital  stock  of  banks,  539 
certificates  of  deposit,  546 
hospitals,  720 
ledgers,  subsidiary,  398 
municipal  accounting,  688 
notes  and  securities  in  banks, 

545 
stockbrokers,  559 
trust  funds,  551 
preparation  of  system  of,  467 
public  utilities,  uniform  system, 
631 
Accounts  payable,  verifying,  147 
Accounts  receivable, 
borrowing  on,  177 
confirmation  of,  319 
fictitious,  75 


from  subsidiary  companies,  512 
general,  71 
schedule  of,  370 
test  of,  77 
valuation  of,  73 
verification  of,  78,  308 
written  off,  328 
Accounts    stated,    when    binding, 

190 
Accrued  expenses,  225 
Accumulated  dividends,  as  a  lia- 
bility, 197 
Actions  at  law,  expenses  of,  473 
Adams,  Prof.  H.  C,  on  deprecia- 
tion, 414 
Advances,    not    accounts    receiv- 
ables, 76 
Advantages  of  an  audit,  9 
Advertisements,   misleading;   mis- 
use of  reports  in,  290 
Advertising, 
charges,  456 

cost   percentage   in   retail   busi- 
ness, 622 
Advertising  agencies,  742 

internal  audit,  742 
Agency  accounts  of  branches,  376 
Agents'     reserve,     verifying     ac- 
counts in  bank  audits,  537 
Agreement,  partnership,  185 
Allowances, 
rebates,  208 
returns,  351 
Amateur  auditors,  5 


867 


868 


INDEX 


American    Association    of    Public 
Accountants, 
insurance    accounting    methods, 

581 
public   utilities   classification   of 
accounts.  640 
American  Bankers'  Association, 
form  of  statement  for  borrow- 
ers, 256 
American  Gas  Light  Association, 
classification  of  accounts  basis, 
Public  Service  and  Interstate 
Commerce     Commission     re- 
quirements, 676 
American  Malting  Co., 
directors'    liabilities,    court    de- 
cision on,  232,  332,  751 
Amortization, 
bond    premiums    and    discount, 

374 
general,  130 

N.  Y.   Public   Service  Commis- 
sion on,  408 
reserve,     telephone     companies, 
680 
Anticipation, 
of  earnings  and  profits,  ^)9 
on  sales  not  delivered,  214,  331 
Appraisals  (See  "Valuation") 
Appreciation  of  assets,  216,  470 
Appreciation  of  securities, 

book  value  not  advanced,  SS'i 
Architects,  728 
certificates  of,  380 
commissions  earned,  729 
Arrears  of  dividends,  197 
Assessments,  on  capital  stock,  137 
Assets, 
appraisals  of,  434 
appreciation    in    value    of,    216, 

470 
changeable, 

verification  in  banks,  535 
contingent,  136 


current,  proportion  to  liabilities, 

65 
current,  verification  of,  61 
fixed,  104 
omission   of,   on  balance  sheet, 

144 
profit  on  sale  of,  216 
sale  of,  470 
verification  of,  60,  372 
wasting,  134,  195,  232 
writing  down,  141 
Asylums    (See  charitable  organi- 
zations, 719) 
Audit, 
advantage  of  an,  21 
balance  sheet,  50 

limitations  of,  60 

principles  of,  59 
banks,  national  and  state,  531 
beginning  an,  29 
cash  audit,  timing  of,  69 
cash  book,  discussed,  47 
certificate  of,  243 
completed,  293 
continuous,  293 
detailed,  48,  293 
determination  of  type  of,  46 
fees,  33,  162 
interim,  294 
internal, 

advertising  agencies,  742 

railroads,  651 

agents'  accounts,  652 
minor  objects  of,  12 
of  prior  periods,  297,  433 
place  of,  37 

procedure  in  banks,  535 
procedure  in  case   of  previous, 

45 
program, 

banks    and    trust    companies, 
545 

building  and  loan  associations, 
566 


INDEX 


869 


Audit — continued 
program — continued 

land  and  development  compa- 
nies, 740 

retail  merchants,  610 

stockbrokers'  accounts,  561 

wholesale   merchants,   608 
purposes  and  advantages  of,  9 
scheduling  books,   records,  and 

clerks'  names,  45 
single-entry  books,  44 
special  points  in  different  classes 

of,  530 
unfamiliar  business,  43 
working  papers,  38 
Auditing, 
accounting  clistinguished  from,  1 
business  man's  attitude,  2 
by  tests  and  scrutiny,  295 
profession  of,  4 
Auditor, 
advisory  capacity  of,  186 
as  lawyer,  108 
as  teacher,  21 
bank  audit  report,  542 
bank    audits    and    responsibility 

of,  542 
certificates  and  reports  of,  235 
experience  necessary,  3,  43 
fees,  33 

fees,  contingent,  36 
legal  duties  summarized,  7 
liabilities  summarized,  7 
liability  for  failure  to  discover 

defalcation,  13 
liability  for  negligence,  8 
must  not  prophesy,  460 
non-professional,  5 
not  an  appraiser,  86-87 
not  an  insurer,  7 
recovery  against  for  negligence, 

28 
tact  essential,  33 


testimony   as    expert    in    court, 

438 
working  papers  of,  38 
Authorization,  ledger  transfers  in 

banks,  541 
Automobile,  depreciation  of,   118, 

426 
Automobile  dealers,  626 
branch  accounts,  628 
inventories,  627 
reserve  for  repairs,  627 

B 

Bad  accounts,  208,  371 
Balance,  depositors'  accounts, 

ledger  and  pass-book  to  be  re- 
conciled, 539 
Balance  sheet, 

bank  audit,  verification  of  items, 
535 

building    and    loan    association, 
form  of,  571 

charitable     organization,     New 
York  City,  722 

consolidated,  508 
branch    and    home    office   ac- 
counts, 628 

form  of,  247 

holding  companies,  508 

life  insurance  company,  582 

manufacturing      accounting; 
American  form,  590 

manufacturing  accounting ;  Eng- 
lish form,  591 

municipal, 
capital  account,  698,  708,  710, 

711 
consolidated,  704,  711 
fund,  701,  709 
general  account,  697,  706 
trust  fund,  700,  710 

object  of,  191 

omissions  from,  150 

taxicab  company,  666,  668 


870 


INDEX 


Balance  sheet  audit,  50,  59 
Baltimore  &  Ohio  R.  R.  Co., 

receivership  1896,  causes  of,  653 
Bank  audit,  531 
auditor's  report,  542 
building,  valuation  of,  142 
capital  stock  certificates,  539 
cash  and  securities,  535 
cashier's  cheques,  538 
certificates  of  deposit,  538 
certified  checques,  538 
charges  for  acceptances,  177 
correspondents'  accounts,  537 
defalcation  by  means  of  collec- 
tion items,  543 
defalcation,  detection  of,  543 
demand  notes,  537 
depositors'  accounts,  539 
monthly  statements  to  depos- 
itors, 540 
pass-book  and  ledger  to  be  re- 
conciled, 539 
statements     on     inactive     ac- 
counts to  depositors,  539 
expense  accounts,  541 
income,  verification  of,  540 

discounts  unearned,  540 
loans  exceeding  10%  capital  and 

surplus,  546 
national  bank,  531 
procedure, 

bonds  and  securities,  545 
cash,  545 

cashier's  cheques,  546 
certificates  of  deposit,  546 
correspondents'  accounts,  546 
employees'  bonds,  547 
employees'  duties,  547 
notes,  545 
overdrafts,  546 
savings  bank,  547 

deposit,  limit  on  amount,  550 
discounting  notes  not  allowed, 
547 


insurance    on    property    mort- 
gaged, 547 
investments,  547 
Massachusetts   form   of  audit 
report,  548,  549 
state  bank,  531 
stock  ledger,  539 
Bank  balances,  verification  of,  304 
Bank    examiners'    fees,    fixed    by 

Federal  Reserve  Board,  531 
Bank  loans,  value  of  audit  for,  22 
Banks, 

certified  statements  for,  51 
credit  information,  146 
interest  rule  of,  524 
statements  of,  304 
statements  required  by,  252 
Bonding  employees,  355 
advantage  of  audit  in,  26 
of  bank,  547 
Bonds,  157 
auditing,  388 
discount  on,  349 
premium  and  discount  on,  374 
valuation  of,  130 
verification  in  bank  audit,  545 
Bonds  and  mortgages,  132 
Book  publishers,  592 
Books  and  records, 
precautions  in  handling,  435 
styles  of,  391 
Borrower's  statement,  253-265 
Branch  accounts,  376 
foreign,  automobile  dealers,  630 
internal  check  for,  57 
Breweries,  audit  of,  602 
Budget, 

municipal  accounting,  685 
Building  and  loan  association,  565 
balance  sheet,  form  of,  571 
capital  stock,  statement,  of,  572 
income  verification  of,  567 
dues  and  fines,  567 
interest  on  loans,  567 


INDEX 


871 


Building    and    loan    association — 
continued 
profit  and  loss  account,  form  of 

report,  572 
profits,  distribution  of,  569 
securities  owned,  verification  of, 
568 
Building  lots,  sale  of,  333 
Buildings, 
depreciation  of,  419 
payments  on,  379 
valuation  of.  111 
Buildings   and   land,   encumbered, 

107 
By-laws,  building  and  loan  asso- 
ciation; examination  of,  567 


Calls     and     assessments,     capital 

•     stock,  137 
Cancellation  of  vouchers,  368 
Cannon,    James    G.,    on    certified 

statements,  257 
Capital, 
insufficient,  462,  498 
proportion  of,  to  current  assets, 

65 
reserve  for  working,  196 
revenue  distinguished  from,  230 
Capital    charges,    public    utilities, 

637 
Capital  expenditures,  377 
Capital   payments,   cash   discounts 

on,  378 
Capital  stock, 
auditing,  192,  388 
building    and    loan    association, 

566,  572 
calls  and  assessments,  137 
issue  to  be  verified  with  general 

ledger,  539 
premiums,  194,  375 
surplus  and,  190,  376 
unissued,  134 


Cash, 

in  bank,  audit  of,  67 

internal  check  for,  53 

on  hand,  audit  of,  68 

petty,  internal  check  for,  53 

transfer  from  cages  and  vaults 
while  auditing,  536 

verification   of,   in   bank   audit, 
535 
Cash  book, 

falsification  of,  307 

tabular,  254 
Cash  discounts,  226,  317,  378 
C.  O.  D.  shipments   (See  depart- 
ment stores,  616) 
Cash  payments,  309 
Cash  receipts,  306 
Cashier,  duties  of,  296 
Casualty  insurance,  587 
Census  Bureau,  U.  S., 

water  supply    systems,  uniform 
accounts,  678 
Certificates, 

and  reports,  235 

audit,  243 

deposit  (See  "Deposit") 

of  stock,  193 

qualifications  in,  244 
Charitable  organizations, 

Chicago    Association    of    Com- 
merce, report  on  audit  of  ac- 
counts, 721 

contributors,  receipts  from,  719 

New  York  City,  report  required 
by,  722 

state  appropriations,  720 
Charts  and  graphs. 

preparation  of,  281 

use  of,  276 
Checking,  internal, 

banks,  541,  552 

insurance  companies,  575 

retail  merchants,  610 


872 


INDEX 


Cheques, 
cashier's, 
stubs  deposited  in  locked  box 

for  auditing,  538 
verification     of     balances     in 
bank  audits,  538,  546 
certified,  verification  of  account 

in  bank  audit,  538 
deposits  of,  303 
receipts  constituted  in,  334 
unpaid  by  clearing  house  to  be 

reported  to  auditor,  536 
verification  of,  309 
Chicago  Association  of  Commerce, 
charitable      organizations,     sub- 
scription   investigations    com- 
mittee report,  721 
Churches    (See  institutional,  725) 
Circulation, 
bonds  of  national  banks  to  U.  S. 

Treasurer,  538 
redemption     fund     of     national 
banks,  538 
"Circulation  audits"  (See  publish- 
ers, 599) 
Clearing  house, 
items  to  be  verified  in  auditing 

bank,  536 
stock  exchange,  557,  558 
Clerks,  scheduling,  45 
Client, 
auditor's  relation  confidential,  8 
fixing  responsibility  of,  29 
instructions  from,  431 
staflf.  of,  31 
Clothing,  costs  in  retail  business, 

622 
Clubs, 
accounting  in,  726 
depreciation  of  property,  728 
embezzlements,  726 
members'  accounts,  726 
Coal  mines  (See  "Mines") 


Collateral,   verifying  in  bank  au- 
dits, 536,  538 
Collection  charges,  361 
Collections, 
internal  check  for,  56 
unaccounted  for,  318 
Columnar  ledgers,  398 
Commission,  162,  357 

errors,  19 
Commissioner  of  Corporations,  125 
Commissions,  rulings  of. 
Interstate  Commerce   (See  "In- 
terstate   Commerce    Commis- 
son") 
New    Jersey    Board    of    Public 
Utility    Commissioners ;    pres- 
ervation of  investment  values, 
643 
Public  Service  Commission  (N. 
Y.)  ;  depreciation,  638 
Compensation, 
contingent  fees  as,  36 
of  auditor,  33 
Competition,  466 
Completed  audit,  293 
Comptroller     (See    "New     York, 

City  of") 
Comptroller     of     Currency     (See 

"United  States") 
Compulsory  reports,  292 
Concealment, 
of  railroad's  financial   standing, 
by  incorrect  charges  to  capital 
accounts,  650 
reserve,  secret;  created  by,  138 
Condition  of  affairs,  value  of  audit 

for  ascertaining,  22 
Confirmation, 
customers'  accounts,  319 
savings     bank     depositors'     ac- 
counts, 550 
slips, 
cheques  sent  through  clearing 
house  verified,  536 


INDEX 


873 


Confirmation  slips — continued 
method  of  handling,  536 
securities  in   hands  of  trans- 
fer agents,  561 
Consigned  goods,  71,  153,  328 
Construction,  expenditures  in  pub- 
lic utilities,  636 
Containers,  117 
deposit  for,  117 
empty,  354 
Contingent  assets,  136 
Contingent  fees,  36 
Contingent  liabilities,  168 
Continuous  audit  defined,  293 
Contractors,  733 
architect's    certificate    for    pay- 
ment to,  734 
contract  unit  of  accounting,  733 
depreciation,  734 
Contracts,  474 

unfulfilled,  178 
Controlling   accounts     (See    "Ac- 
counts, Controlling") 
Coolcy,  Prof.  M.  E.,  on  causes  of 

depreciation,  404 
Co-operation  with  client's  staff,  31 
Copying  devices,  393 
Copyrights,   121 

valuation  on,  595 
Corporations,    directors'    liability, 

748 
Correspondence,  verification  by,  78 
Correspondents'    accounts    to    be 
verified   in   bank   audits,   537, 
546 
Cost,  interest  as  element  in,  95 
Coupons,  164 
bonds,  389 
Coart  decisions,  public  utilities, 
depreciation      (Idaho     Supreme 

Court),  638 
replacements    (U.    S.    Supreme 
Court),  639 
Cravens,  Geo.  A.,  rates  of  depre- 


ciation, 424 
Credit,  bank ;  purpose  of,  146 
Credit  manager,  statement  for,  268 
Credit  purposes,  investigation  for, 

492 
Creditors, 

investigation  for,  484 

trade,  150 
Cumulative  dividends,  197 
Current  assets, 

proportion  of,  to  labilities  and 

•     capital,  65 

verification  of,  61 
Customers'  accounts,  308 

internal  check  for,  56 
Customs  as  to  interest,  524 


D 


Damages  as  liabilities,  163 

"Dating"  invoices,  152 

Debts,  bad,  208 

percentage  in  retail  business,  622 

Decedents'    estates,   principal   and 
.income,  232 

Defalcation     defined,     507     (See 
"Embezzlement"  ) 

Deferred  assets  and  accounts  re- 
ceivable, 77 

Deferred  charges,  456 
to  operation,  102,  332 

Delivery, 

cost   percentage   in   retail   busi- 
ness, 622 
department  store  cost  of,  621 

.    equipment,  118 

Departmental  profits,  211 

Department  stores,  616 
C.  O.  D.  shipments,  616 
cost  of  doing  business,  622 
delivery  cost  per  package,  621 
inventory       calculation,       retail 

method,  620 
turnover,  624 


874 


INDEX 


Departments,  check  on,  397 
Deposit,  certificates  of, 

defalcations  by  means  of  fraudu- 
lent, 544 

stubs  deposited    in    locked  box 
for  auditing,  538 

verification   in  bank  audit,  538, 
546 
Depositors'  accounts, 

trial  balances,  539 

verification  in  bank  audit,  539 
Deposits, 

assets,  current,  78 

interest  on,  469 

liabilities,  164 

on  sales,  332 

savings  bank;  limit  on  amount, 
550 
Depreciation,  401 

calculation  of,  406 

causes  for,  404 

club  property,  728 

coal   mines   and   mineral   lands, 
605 

compulsory, 
railroad  equipment,  633,  652 
shipping  companies,  Interstate 
Commerce  Commission,  654 

contractors,  734 

defined,  402 

definition    by    Idaho     Supreme 
Court,  638 

distinguished  from  sinking  fund, 
412 

doctors,  731 

electric  light  and  power  compa- 
nies, 675 

exhaustion  due  to,  411 

fixed  percentage  basis  of,  406 

gas  companies,  676 

horses,  426 

hotels,  741 

investment  companies,  553,  554 

investment  of  reserve  for,  415 


leaseholds,  421 

local  issue,  415 

machinery,  114 

method   of  applying   on   books, 
406 

method  of  calculating, 
percentage  of  plant  values.  588 
production,  rate  per  unit,  588 

operating  expense,  413 

place  of,  in  profit  and  loss  ac- 
count, 222 

property,  different  classes,  417 

public  utilities,  635 

rates  of,  417 

reserve,  415 
telephone  companies,  682 

shoes,  retail  stores,  615 

shrinkage  and,  retail  business, 
622 

sinking  fund  method,  407 

telephone  companies,  680,  682 

textile  industries,  588 

theatrical  companies,  747 

tools,  small,  116 
Detailed  audit,  48,  293 
Detection  of  errors,  15 
Dickinson,  A.  Lowes, 

depreciation,  mineral  lands,  605 

profit  and  loss  statement,  274 

valuation  of  marketable  invest- 
ments, 556 
Directors, 

bank, 
attendance  at  meetings,  536  " 
examination      in     accordance 
with    Comptroller    of    Cur- 
rency suggestions,  545 
responsibilities,  534 

books  of  corporation  open  to  in- 
spection of,  750 

compensation  of,  749 

liability  of,  138,  748 

court  decision    (N.  Y.), 
American  Malting  Co.,  751 


INDEX 


875 


Discarded  machinery,  115 
Discount,  152 
bank    should    maintain    reserve 

for  unearned  items,  540 
bonds,  349 

amortization  of,  374 
capital  payments,  378 
cash,  226,' 317 
department  stores,  153 
prepayment,  325 
register   as   check   on   loans   in 

banks,  543 
trade,  227,  325 
Discounted  notes  receivable,  169 
Dishonored  notes,  82 
Dissolution  of  partnership,  187 
District  of  Columbia, 
electric   light   and    power   com- 
panies under  Interstate  Com- 
merce Commission,  672 
Dividends, 
capital  used  to  pay,  230 
cash,  386 

declaration  of,  229 
investment  companies,  553 
liability,  197 

principal  or  income,  233 
stock,  386 
stock  and  (extraordinary)  cash, 

233 
stockholders  and,  141 
unclaimed,  166 
Doctors,  730 

depreciation*  731 
Doubtful  accounts,  371 
ledger  of,  371 
schedule  of,  371 
Drafts, 
medium  of  defalcation  in  banks, 

537 
on    correspondents    or    reserve 
agents,  to  be  verified  in  bank 
audit.  537 


unused  to  be  accounted  for  in 
bank  audit,  537 
Drawings,  118 

partners',  385 
Drugs,  costs  in  retail  business,  622 
Dry  goods,  costs  in  retail  business, 

622 
Duties,  vouching  of,  361 


Earnings,  207 
gross,  207 

public  utilities,  634 
net, 
public  utilities,  634 
Efficiency  engineer,  390 
Efficiency  of  organization,  399 
Efficiency   theory   in   office   work, 

400 
Electric  light  and  power  compa- 
nies, 672 
classification     of     accounts     re- 
quired. 
Interstate     Commerce     Com- 
mission (District  of  Colum- 
bia), 672 
Public     Service     Commission 
(New  York),  672 
depreciation,  675 
Electrotypes,  valuation  of,  120 
Embezzlement,  472 
bank, 
certificates  of  deposit,  fraudu- 
lent, 544 
collection   items    manipulated, 

543 
drafts    on    correspondents    a 

medium,  537 
examiners'   inability   to   audit 
completely     contributes     to, 
533 
individual  holding  position  in 

two  institutions,  544 
loan   record  manipulated,  542 


876 


INDEX 


Embezzlement — continued 

defined,  506 

discount   register  as  preventive 
of,  543 

insurance  funds,  575 

interest  account  in  stockbroker's 
office  as  means  of,^564,  565 

money  or  goods,  13 

"over    and    short"    account    as 
means  of,  544 

railroad,  652 

real  estate,  737 

telephone  companies,  680 

theater  accounts,  745 
Embezzler,  attitude  toward,  505 
Employees, 

bonds  of,  355 

sales  to,  611 
Empties,  353 
English    Companies    Act    balance 

sheet,  591 
Entertaining  expense,  357 
Entries, 

false,  435 

transfers,  require  authorization, 
541 
Equipment,  depreciation  of,  422 

railroads,  633,  652 
Erasures,  437 
Errors, 

classified,  15 

clerical,  16 

detection  of,  15 

in  the  books,  477 

of  commission,  19 

offsetting,  19 

of  omission,   17 

of  principle,  16,  498 
Estates, 

decedents,  232 

executors'     and     trustees'     ac- 
counting, 713 

lawyers'  accounts  of,  732 
Evidence,  books  as,  436 


Examination,    federal    reserve 

bank,  531 
Examiners,  bank ;  clearing  house, 

533,  534 
Executors  and  trustees,  713 
commissions  allowed,  714,  715 

New  York  State,  715 
estate,  division  or  partition,  717 
interest  on  funds  applied  to  own 
use  chargeable  to  trustees,  715 
inventory  of  estate^  713 
investments, 
legality,  715 

losses  on  unauthorized  or  ille- 
gal   investments    chargeable 
to  trustees,  715 
principal     and     income ;    appor- 
tionment of  receipts  and  pay- 
ment, 715 
real  estate,  714 
securities,  audit,  713 
Expenditure,  capital,  377 
Expenditures,    extraordinary,    348 
Expenses, 
accrued,  225 
audit  of  in  banks,  541 
extraordinary,  348 
general,  retail  business,  622 
income  and,  audit,  296 
losses  and,  219 

operating,  public  utilities,  640 
organization,  345 
public  utilities,  635 
Export    accounts     maintained    in 
United  States  and  foreign  cur- 
rency, 609 
Express  and  freight  expenses,  363 
Extensions,  381 
Extraordinary  expenses,  348 


Federal  Reserve  Act,  175 
Federal  Reserve  Board, 
acceptances,  178 


INDEX 


877 


Federal  Reserve  Board — continued 
borrower's  statement,  262 
requirements  for  borrowers,  263 
Fees, 
auditor,  33 
bank  examiner,  531 
Filing  auditor's  working  papers,  42 
Filing   system,    essential    features 

of,  392 
Financial     (See    Banks,    Building 
and    Loan    Associations,    In- 
vestment,   Speculation,    Trust 
Companies) 
Finished  goods,  value  of,  94 
Fire  insurance,  574 
Fire  loss,  472 

value  of  audit  for  proving,  25 
Fixed  assets,  104 
defined,  104 
valuation,  104 
Fixtures, 

furniture  and,  116 
landlord's,  425 
Flax   crops,   depreciation  of  land 

by,  419 
Floy,  Henry^ 
on  obsolescence.  405 
on  public  utility  property  valu- 
ation, 647 
Fluctuation, 
depreciation  and,  402 
reserve,    investment    companies, 
554 
Footings,  verification  of,  297 
Forced  balances,  300 
Forgan.  James  B., 
on   employment  of  auditors  by 

bank  directors,  534 
on  responsibility  of  bank  direc- 
tors, 534 
Forgery, 
capital  stock  certificates  of 

banks,  539 
false  entries  and,  435 


notes  forged  to  cover  shortage 
in  bank,  543 
Fraud  (See  also  "Embezzlement") 
accounts  receivable  and,  302 
audit  not  an  insurance  against,  7 
capital    stock    certificates    mis- 
used, 539 
defined,  506 
detection  of,  12 
in  bankruptcy  cases,  498 
in  banks,   542    (See  also   "Em- 
bezzlement") 
cashiers'  checks  as  means  of, 

538 
certificates     of      deposits     as 
means  of,  538 
in  investigations,  435 
pay-roll  padding,  617 
sales  accounts,  452 
stockbroker's  accounts,  564 
"trusted  employee"  and,  502 
Freight,  161 

and  express  expenses,  363 
Fund, 
circulation  redemption,  national 
bank ;  to  be  verified  by  Treas- 
urer of  U.  S.,  538 
reserve,  130 
sinking,  128 
Fund  investments,  130 
Furnaces,  blast;  method  of  figur- 
ing depreciation,  588 
Furniture, 
costs  in  retail  business,  622 
fixtures  and,  116,  425 
Future  delivery,  sales  for,  214 


Gambling,  343 
Gas  companies,  675 
depreciation,  676 
"Going     concern"      and     "scrap' 

valuations,  107 
Gold  mines  (See  "Mines") 


878 


INDEX 


Goods, 

in  process,  92 

received  for  sale,  329 
Good-will, 

depreciation  of,  427 

valuation  of,  123 
"Graft,"  349 
Graphs  and  charts,  276 
Grocery,   costs  in   retail  business, 

622 
Gross  earnings,  207 
Guarantees,   as   contingent  liabili- 
ties, 173 

H 

Hardware,  costs  in  retail  business, 

622 
Harvard    University,    Bureau    of 

Business  Research, 
retail  shoe  store  standard  form 

profit  and  loss  account,  613 
Heat  and  light,  cost  percentage  in 

retail  business,  622 
Holding  companies,  508 
Horses, 
depreciation  of,  426 
valuation  of,  118 
Hospitals  (See  charitable  organiz- 
ations, 719) 
Hotels,  741 

depreciation,  741 
Hutchinson  and  McElheny,  Jr.,  v. 

Curtiss    and    The    American 

Malting  Co.,  752 
Hypothecations  and  liens,  61,  272 


Implements, 

costs  in  retail  business,  622 
Import     accounts     maintained    in 

United     States     and     foreign 

currency,  609 
Imprest  system,  344 
Improvements,  381 


Income, 
expenses  and,  audit,  296 
extraordinary     stock    dividends 

and,  233 
investments,  322 
principal  and,  230 
verification  of,  313 
building  and  loan  association, 
567 
Income  tax,  federal    (See  special 
index  in  income  tax  section) 
insurance  companies,  587 
Indorsements  as  liabilities,  170 
Information  not  volunteered,  140 
Instalment  contracts,  83 
Institutional  accounting,  718 
charitable  organizations,  719 
churches,  725 
clubs,  726 
educational,  718 
securities    and    their    income, 
718 
Instructions,   client's,  431 
Insufficient  capital,  462 
Insurance, 
companies  (See  below) 
firm,  188 
merchandise    on    hand    governs 

amount  of,  612 
mortgages  protecting  loans, 

property  requires,  547 
policies  as  guides  to  title,  62 
premiums,  362 
profit,  471 

self,  shipping  companies,  655 
sufficiency  of,  497 
taxes  and,  cost  percentage  in  re- 
tail business,  622 
Insurance  companies, 
accounts,  573 
casualty,  587 
embezzlement,  575 
fire,  574 

embezzlement,  575 


INDEX 


879 


Insurance  companies — continued 
fire — continued 
liabilities,  577 

liabilities,  reinsurance  reserve, 
577 
health,  587 

income  tax  rulings,  587 
investments,  legal,  578 
life,  577 
accounting  forms    and  meth- 
ods, 581 
administration     and     general 

expenses,  586 
agency  accounts,  585 
assurance  account,  584 
investments,  verification,  578 
reserves,  calculation,  580 
marine   and    inland   navigation, 
587 

reserve,  as  a  liability,  184 
title  guarantee,  587 
valuation  of  securities, 
convention  of  commissioners, 

578 
State  (N.  Y.)  Superintendent, 
578 
Interborough-Metropolitan  Co., 

dividends  of,  231 
Intercompany  profits,  213 
Interest, 
calculating,  method,  520 
charges,  361 
element  of  cost,  95 
on  deposits,  469 
payable,  159 

principal  or  income,  233 
receivable,  verification,  323 
Interim  audits,  294 
Internal  check,  50,  53 
International  Harvester  Co.,  125 
rules  as  to  profits  on   forward 
sales,  215 
Interstate  Commerce  Commission, 
accounts,  uniform  system,  632 


depreciation   of   railroad   equip- 
ment, compulsory,  633,  652 

depreciation    of    railroad    track 
and  structure,  optional,  652 

depreciation  of  vessels,  compul- 
sory, 654 

telephone  companies ;  fixed  capi- 
tal, additions  at  cost,  681 
Inventory,  57,  84,  374,  459 

department  store,  619 

discount  in  retail  shoe  business, 
615       - 

finished  goods.  94 

goods  in  process,  92 

insurance  carried  dependent  up- 
on, 612 

perpetual,  394 

reserves,  secret,  and,  140 

retail  method  of  calculating,  620 

supplies,  stores,  etc.,  98 

turnover  and,  98 

valuation  of,  99,  140 

verification  of,  88 

wholesale    establishment,    calcu- 
lations  and   prices   should  be 
checked,  609 
Investigations,  430,  431 

purposes  of  summarized,  10 
Investment, 

authority  in  minutes,  536 

companies,  552 
dividends,  553 
fluctuation     reserve     account, 

554 
income,  553 

reserve  account,  553,  554 
securities  purchased  and  sold, 

553 
valuation  of  investments,  553, 
554 

income  from,  322 

insurance  companies,  578 

of  funds,  130 

of  surplus,  199 


88o 


INDEX 


Investment — continued 
requires   investigation,  536 
savings  banks,  547 
temporary,  101 

Investment  securities,  inventory 
of,  99 

Investor,  balance  sheet  for,  191 

Invoices,  purchase,  337 

Irish  Woolen  Mill  Company,  Ltd. 
V.  Tyson  and  others,  341 

J 

Jewelry,  costs  in  retail  business, 
622 

Jones  V.  Terre  Haute  and  Rich- 
mond R.  R.  Co.  (interest  of 
stockholders  in  corporation), 
386 

Journal  vouchers,  366 

Judgments,  158 


Kansas  City  Southern  Railway  v. 
Interstate  Commerce  Commis- 
sion, 639 

Kings  County  Lighting  Co.,  Court 
of  Appeals  (N.  Y.),  decision 
on  rate-making  for  public 
utilities,  643 

Kingston  Cotton  Mill  Co.,  in  re,  90 

L 
Land, 

buildings  and,  107 

depreciation  of,  421 

valuation  of,  109 
Land  and  development  companies, 

738 
Landlords'  fixtures,  425 
Lasts,  118 
Lawyers'  accounting,  731 

client's  funds,  732 

personal  funds,  732 
Lawyers  and  accounting,  203 
Leake,  P.  D.,  on  depreciation,  402 


Leaseholds, 

depreciation  of,  421 

sinking  fund  for,  112 

valuation  of.  111 
Leases,  investigation  of,  457 
Ledgers, 

columnar,  398 

self-balancing,  398 

subsidiary,  398 
Legal  expenses,  162,  349 
Liabilities,  146 

auditor's,  6,  7 

contingent,  168 

directors',  138,  748 

importance  of,  in  balance  sheet 
audit,  146 

proportion  to  current  assets  and 
capital,  65 
Liability  and  assets  items,  372 
Liens  and  hypothecations,  61,  272 
Life  insurance,  577 
Lighting  (See  "Electric  Light  and 
Power  Companies"  and  "Gas 
Companies") 
Loans, 

rules  for,  147 

unsecured,    savings     binks    not 
permitted  to  make,  547 
Loose-leaf  records,  436 
Losses  and  expenses,  219 
Lybrand,  Wm.  M.^ 

holding  companies,  508 

intercompany  profits,  213 

M 

Machinery, 
discarded,  116 
equipment  and, 
depreciation  of,  422 
valuation  of,  113 
purchase  of,  383 
Machine  shops,  method  of  calcu- 
lating depreciation,  588 
Magazine  publishers,  596 


INDEX 


88 1 


Mail  books,  343.  365 
Mail,  handling  of  incoming,  53 
Mail  order,  costs  of  doing  busi- 
ness, 622 
Mailing  department,  393 
Maintenance,  405 
asset  accounts,   secret   reserves, 
and,  138 
•     expenditures,      public      utilities, 

636 
Manipulation  of  accounts,  14 
Manufacturing, 
accounts,  587 
and  trading  profits,  anticipation, 

210 
balance  sheet, 

American  form,  590 
English  form,  591 
cost  records,  589 
freight  charges,  checking,  588 
purchase  invoices,  checking,  588 
receiving  records.  588 
stock  records,  589 
wages,  audit,  588 
Marine  insurance,  587 
Massachusetts,    State   of ;    savings 
bank  audit  report  to,  548,  549, 
550 
May,    Geo.    O.,   expenses   of   sea- 
sonal business,  346 
Memorandum  books,  314 
Memorandum,  goods  on,  328 
Mercantile    agencies,     forms     for 
statements  of  financial  condi- 
tion. 266 
Merchandising, 
retail,  610 
wholesale,  608 
Metz  Fund, 
"Municipal  Accounting  and  Re- 
porting, Short  Talks,"  690 
Mileage  account,  358 
Mines,  603 
coal.  603 


depreciation,  195,  428,  605 
gold,  607 
valuation,  135 
Minute  book, 
building    and   loan    association; 

examination    of,   567 
contingent  liabilities  shown,  179 
Misappropriation,  defined,  507 

(See  "Embezzlement") 
Mortgages,  156 
bonds  and,  132 
coal  or  ore  lands,  606 
registry  of,   156 
Municipal, 
accounts  (See  below) 
bond  issues,  686 
departments,  687 
ownership,  water  works,  678 
revenue,  691 

-assessments,  692 

franchises,  692 

rents,  692 

taxes,  691 
Municipal  accounts,  685 
accounts  outstanding,  audit,  693 
balance  sheet,  697,  706 

capital  account,  698,  708,  710, 
711 

consolidated,  704,  711 

fund,  701,  709 

general  account,  697,  706 

trust  fund,  700,  710 
budget,  preparation,  685 
controlling  accounts,  688 
equipment,  audit,  693 
examination,  periodical,  690 
expenditures,  audit,  693 
financial  statements,  695 
operations,     surplus     or     deficit 

statement,  707 
property  and   equipment,   audit, 

693 
revenue,  686 

audit  of,  691 


88: 


INDEX 


Municipal  accounts — continued 
sinking  funds,  694,  709 
tax  rate,  method  of  fixing,  686 

Murray  v.   Public  Utilities   Com- 
mission, Idaho,  638 


N 


National  Association  of  Credit 
Men,  statement  recommended 
by.  270 

National  City  Bank  (N.  Y.),  bank 
examination  by  directors,  545 

National  Civic  Federation,  mu- 
nicipal and  private  operation 
of  public  utilities  report,  642 

Negligence, 
auditor's  liability  for,  8 
of    auditor,    right    of    recovery 
for,  28 

Net  profits, 
defined,  204 
standardization  of  term,  220 

Newspaper  publishers,  596 

New  works  in  place  of  old,  138 

New  York,  City  of;  charitable  in- 
stitutions report  to  Comptrol- 
ler, 722 

New  York  Clearing  House,  cus- 
tom as  to  interest,  526 

New  York  Public  Service  Com- 
mission, on  amortization,  408 

New  York  Railways  Co.,  accident 
reserve,  663 

New  York  statute  as  to  interest, 
528      • 

New  York  Stock  Corporation  Law 
on  dividends  from  capital,  230 

New  York  Telephone  Co.,  ap- 
praisal of  property,  684 

New  York  Third  Ave.  Ry.  Co. 
amortization,  408 

Nominal  accounts,  307 

Non-professional  auditors,  5 


Notes, 
demand,  confirmation  of  amount 

by  borrower,  537 
held   by  bank's    correspondents 

to  be  verified,  538 
payable, 

concealing  personal  loans,  154 

vouchers  of,  384 
receivable,  373 

audit  of,  80 

discounted  as  liabilities,  169 

discounted  on    balance  sheet, 
81 

protested,  373 

questionable     in     department 
stores,  619 
savings  banks  not  permitted  to 

discount,  547 
verifying    discounted    items    in 

bank  audit,  536 


Obsolescence,  224 

depreciation  due  to,  404 

machinery,  115 

provision  for,  416 
Office  methods,  389 
Offsetting  errors,  19 
Omission,  errors  of,  17 
Operation,    deferred;    charges   to, 

102 
Opinions  and  conclusions,  441 
Order  and  receiving  records,  150 
Order  books,  315 
Organization, 

efficiency  of,  399 

expenses,  345 
Orphanages    (See    charitable    or- 
ganizations), 719 
Outside  enterprises, 

liabilities  in,  172 

loans,  324 
Outstanding  accounts,  370 


INDEX 


883 


Outstandings, 

confirmation  of,  319 

verification  of,  78 
Overdrafts,  bank  audit;  method  of 

handling,  546 
Overdue  accounts,  valuation  of,  72 


Paper,  watermarked,  247 
Participations   and   underwritings, 

215 
Partner,  investigation  for  a  retir- 
ing, 479 
Partners, 
salaries,  473 
withdrawals,  385 
Partnerships,  185 
agreements,  185 
value  of  audit  for,  24 
Pass-books,  54 
ledger    balances    to    be    verified 
with,  539 
Patent  litigation,  investigation  for, 

500 
Patents, 
depreciation  of,  427 
valuation  of,  120 
Patterns, 

valuation  of,  118 
Payments,  internal  check  for,  53 
Pay-roll, 
book,  354 

internal  check  for,  56 
padding,  detection,  617 
padding  prevented  by  compara- 
tive statistics,  287 
vouchers  for,  342 
Peculations        (See       "Embezzle- 
ment") 
Pennsylvania    Railroad    Co.,    re- 
serve for  depreciation  on  roll- 
ing stock,  652 
Percentage  of  profits,  278 
Perpetual  inventory,  394 


Petty  cash, 
imprest  method  of,  342 
internal  check  for,  53 
Physicians'  accounting,  730 
Plates,  120 
Postage,  364 
or  mail  books,  279,  343 
stamps,  102 
vouchers  for,  364 
Postings,  verification  of,  297 
Power,     electric     (See  ."Electric 
Light  &  Power  Companies") 
Preferred  stock,  accumulated  divi- 
dends as  a  liability,  197 
Premiums, 
bond ;  amortization  of,  374 
capital  stock,  194,  375 
-    insurance,  362 
Principal, 
income  and ;  distinction,  230     ' 
method  of  calculating,  520 
Principle,  errors  of,  16,  498 
Profession,  auditing  as  a,  4 
Professional  accounts, 
architects,  728 
doctors,  730 
lawyers,  731 
Profit  and  loss, 
account,  ,201,  514 
building    and    loan    association, 

form  of  report,  572 
statement,  273 
consolidated,  508 
form  of,  A.  Lowes  Dickinson, 

274 
form  of,  retail  shoe  store,  613 
Profits, 
accountants'  definition  of,  205 
anticipating,  331 
contracts  on  maximum,  211 
departmental,  211 
disposition  of,  228 
distribution     of,     building     and 
loan  association,  569 


884 


INDEX 


Profits — continued 
economic  definition  of,  205 
gross  and  net, 
charts,  278 

retail  store  comparison,  623 
insurance,  472 
intercompany,  213 
legal  definition  of,  203 
on  fluctuations,  455 
on  sale  of  assets,  216 
surplus    as    distinguished    from, 
206 
Promotion  expense,  346 
Proof-sheet  of  subsidiary  ledgers, 

398 
Property,    depreciation    rates    on, 

418 
Protested  notes  receivable,  373 
Public,  value  of  audit  in  protect- 
ing, 26 
Public    accountants,    N.   Y.    State 
Society  of  certified, 
insurance    accounting    methods, 
581 
Public     Service     Commission     of 
New  York,  408,  476 
depreciation,  638 
electric   light   and   power    com- 
panies under,  672 
gas  companies  under,  677 
replacements,  638 
telephone  companies  under,  679 
Public  utilities,  631   (See  also  Gas 
Companies,  Light  and  Power, 
Railroads,    Steam ;    Railways, 
Electric;   Shipping;  Taxicab; 
Telephone;  Water) 
appraisals  of,  645^  647 
capital  charges,  637,  650 
construction    expenditures,    636, 

650 
deposits  required  by,  164 
depreciation,  635 


earnings,  gross  and  net,  defined, 

634 
maintenance  expenditures,  636 
Public  Service  Commission  (N. 

Y.),631 
rates,  643 

replacements  not  capital  charges, 
637 
Publishers, 
book,  592 

book  stock,  sheet  and  bound, 

593 
consignment     accounts,     594, 

595 
copyrights,  value,  595 
plates,  value,  594 
royalty  records,  592 
magazine, 

advertising  charges,  597 
subscription  income,  598,  600 
newspaper, 
revenue,  advertising,  597 
revenue,  circulation,  597 
valuation  of  plant,  597 
Pulitzer,  Joseph,  Estate  of,  597 
Purchase  charts,  280 
Purchase  invoices,  337 
Purchase  or  sale  of  a  business,  in- 
vestigation upon,  442 
Purchase  records,  300 
Purchase  returns,  367 
Purchases, 
expenses  and,  342 
internal  check  for,  54 

Q 

Qualification  of  auditor  as  expert 

witness,  438 
Qualifications  in  certificate,  244 
Quick  assets,  61 


Railroads,   steam,   649     (See   also 
"Railways,  Electric") 


INDEX 


885 


Railroads — continued 
depreciation  of  equipment,  com- 
pulsory, 633,  652 
depreciation  of  track  and  struc- 
ture, optional,  652 
earnings,  traffic,  650 
income,  651 
agents'    balances,    verification, 
652 
Railroad    Commission    of   Wis- 
consin ;    telephone   companies, 
depreciation,  682 
Railways  Act  (England),  650 
accounts  certified  prior  to  divi- 
idends,  650 
reserve  for  depreciation,  rolling 
stock,  652 
Railways,  electric,  656    (See  also 
"Railroads,  Steam") 
auditing  department  essential  in 

interurban  operation.  664 
classification  of  accounts,  Inter- 
state  Commerce   Commission, 
656 
depreciation,  660 
reconstruction  charges,  662 
rehabilitation  charges  not  to  be 

capitalized,  661,  662 
reserves,  accident,  663 
Rates, 
interest,  523 
public  utilities,  642 

regulation  of  rates,  642 
Raw  materials,  valuation  of  inven- 
tory, 84 
Real  estate    (See  also  "Land  and 
Development  Companies") 
accounting,  736 
payments  on,  379 
precautions  against  liens  on,  108 
valuation  of,  107 
Realizations  from  profit  and  loss, 

327 
Rebates,  208 


Reckitt,  Ernest, 

holding  companies,  515 

secret  reserves,  145 
Records, 

handling,  435 

loose-leaf,  436 

original  necessary,  437 

scheduling,  45 
Redemption  funds, 

circulation   redemption   fund  of 
national  banks,  538 
Register,  discount, 

defalcation  prevented  by  check- 

•  ing  loans  with,  543 
Renewals  and  repairs,  350 
Renf,  161 

cost   precentage   in    retail   busi- 
ness, 622 

receivable,  74,  326 
Reorganization,  investigation,  483 
Repairs, 

maintenance  and,  405 

renewals  and,  350 
Replacements, 

electric  railways,  660 

maintenance    charge    in    public 
utilities,  637 

valuation,  public  utilities.  639 
Reports, 

auditor's  in  bank  audit,  542 

certificates  and,  235 

clearness  needed,  236 

compulsory,  292 

definite  desirable,  434 

restrictions  on  use  of,  290 

scope  of,  241 
Reserve  funds,  129 
Reserves,  181,  219 

accident,  electric  railway,  663 

amortization,   telephone  compa- 
nies,  680 

balance  sheet  statement,  183 

depreciation, 
electric  railways,  660,  661 


886 


INDEX 


Reserves — continued 
depreciation — continued 
investment  of,  415 
telephone  companies,  682 
discounts  unearned,  540 
excessive,  139 
insurance  company,  184 
life  insurance ;  calculation,  580 
reinsurance,  577 
investment  companies,   553,   554 
secret,  138 
auditor's  attitude  as  to,  145 
auditor's  report  should  cover, 

541 
fluctuation,  402 
working  capital,  196 
Responsibility,   auditor's,   in  bank 

audits,  542 
Restaurants,  742 
Retail  merchants,  610 
cost  of  doing  business,  622 
department  stores,  616 
inventory     calculation     method, 

620 
profit  calculated  on  sales,  611 
profit,  gross,  623 
profit,  net,  623 
shoe  stores,  613 
turnover,  624 
Return  purchases,  367 
Returns,  207 

allowances  and,  351 
Revenue, 
municipal,  686 
audit  of,  691 
sources  of,  688 
taxes,  691 
public  utilities,  640 
Royalties,  475 

coal    mined   from  leased  lands, 
604 

S 
Salaries,  354 
cost  percentage   in   retail  busi- 


ness, 622 
sales,  in  retail  businesses,  623 
Sale, 
goods  received  for,  329 
of  business ;  value  of  audit,  27 
or  purchase  of  a  business ;   in- 
vestigation upon  the,  442 
real  estate,  building  lots,  333 
Sales, 
charts,  276,  290 
future  delivery,  214 
internal  check  for,  55 
not  delivered,  331 
records,  301 

verification  of,  314,  452 
Salesmen's  commissions,  357 
Savings  accounts,  employees',  165 
Savings  banks    (See  "Banks") 
Seasonal  business,  expenses  of,  347 
Secret  reserve    (See  "Reserves") 
Securities, 
investment,  99 
stock-in-trade,  99 
valuation  of,  131 

insurance  companies,  578 
verification, 

audit  of  bank,  535 
building  and  loan  association, 
568 
Self-balancing  ledgers,  398 
Selling  campaigns   as  a   deferred 

asset,  347 
Shipping  companies,  653 
depreciation, 
compulsory.    Interstate    Com- 
merce Commission,  654 
rate  of,  654 
ships,  426 
Interstate    Commerce    Commis- 
sion classification  of  accounts,, 
653 
revenue,  sources  of,  654 
voyage  unit  of  expense  distribu- 
tion, 653 


INDEX 


887 


Shoe  stores,  retail,  613 
costs  in  retail  business,  622,  623 
depreciation,  615 
Single  entry,  audit  of  books  kept 

in,  44 
Sinking  funds,  128,  194 
coal  or  ore  land  mortgages,  606 
depreciation  and,  412 
'     municipal  accounts,  694,  709 

telephone  companies,  680 
Speculative  securities  companies, 

securities  stock  in  trade,  555 
Staff  auditors,  50 
Stamps,  postage  and  other,  102 
Standard  Oil  Co.  of  Indiana,  stock 

dividend  of,  387 
State     insurance      commissioners, 

573 
Statements, 
comparative,  519 
creditors',  150 
depositors'  accounts, 
auditing     inactive     bank     ac- 
counts, 539 
monthly  instead  of  balancing 
pass-book,  540 
financial      condition      (sample), 

238 
for    credit    purposes ;    National 
Association    of    Credit    Men, 
268 
form  of,  for  bankers,  252 
profit  and  loss,  273 
Stationery  of  auditor,  39,  247 
Statistics,  comparative;  value  of, 

•    287 
Stock  accounts,   retail  merchants, 

611 
Stock,  capital,  388 
calls  and  assessments,  137 
certificates,  193 
dividends,  386 
in  default,  198 


precautions     when     purchasing, 

144 
preferred ;  cumulative  dividends, 

197 
premium  on,  194,  375 
retirement  of  special  issues,  198 
subscriptions  to ;  audit,  82 
treasury,  133 
unissued,  134 
verification  of  issue  with  general 

ledger,  539 
watered,  145 
'Stock     Corporation     Law,     New 

York ;  on  dividends,  230 
Stock  on  hand,  394 
Stock  records,  internal  check  for, 

57 
Stockbrokers,  556 

books  of  record,  556 
Stockholders,    value    of    audit   as 

protection,  26 
Stone,  Melville  E.,  Pulitzer  Estate 

valuation,  597 
Stores,  inventory  of,  98 
Subscription  record,  311 
Subscriptions  to  stock  as  asset,  83 
Subsidiaries,  profits  of,  213 
Subsidiary  ledger,  controlling,  398 
Supplies,  98 
cost   percentage    in   retail   busi- 
ness, 622 
Surgeons'  accounting,  730 
Surplus, 
investment  of,  199 
profits  and,  distinguished,  206 
Suspense    accounts     (See    contin- 
gent liabilities,   168,  and  out- 
standing accounts,  370) 
"System"    Magazine,    retail    cost 

data,  621 
Systems  of  accounts,  criticisms  of, 

467 
Systems,  office,  389 


INDEX 


Tabular  ledger,  399 

Tact  necessary  in  auditor,  33 

Taxes,  160 

adjustments  of,  475 

auditing,  389 

avoidance  of,  140 

municipal  tax  rate,  686 
Taxicab  companies,  26,  664 

balance  sheet,  666 

earnings    and    expenses,    state- 
ment, 666,  670 

revenue,  665 
Telephone  companies,  679 

appraisal  of  property,  684 

capital,  fixed ;  additions  at  cost, 
681 

depreciation,  680 

embezzlement      through     direc- 
tories, 68o 

public   service   commission   con- 
trol of,  679 

subscribers  ledger,  681 
Temporary   investments,   101 
Terminology  of  reports,  simplicity 

advisable  in,  236 
Test  defined,  295 
Testifying,  preparation  for,  438 
Textile  industries, 

depreciation,  method  of  figuring, 
588 
Theaters,  743 

pay-rolls,  745 

"settlement  sheet,"  744 
Theatrical  companies,  746 

depreciation,  747 
Theft,   detection  of,  in  wholesale 

establishment,  609 
Third   Avenue   Railway   Co.   case, 

408 
Tickets,  unused,  164 
Timber  lands, 

depreciation  of,  429 

valuation  of,  136 


Time  of  interest,  523 

Title  guarantee  insurance,  587 

Tools,  small,  116 

depreciation  of,  425 
Trade  creditors,  150 
Trade  discounts,  227,  325 
Trading,  608 

retail  merchants,  610 

wholesale  merchants,  608 
Transportation      (See     Railroads, 
Railways,     Shipping     Compa- 
nies, Taxicab  Companies) 
Traveling  expenses,  162,  357 
Treasurer  of  U.  S.    (See  "United 

States") 
Treasury  stock,   133 
Trial  balance,  369 

depositors'    accounts    in    banks, 
539 

forced,  300 
Trust  companies,  550 

departments  maintained,  551 

income,  552 
Trust  funds,  charitable  organiza- 
tions, 721 
Trustees      (See    "Executors    and 

Trustees") 
Turnover,  98,  454 

department   stores,  624 

retail  stores,  624 

U 
Unclaimed  dividends,  166 
Underwritings  and  participations, 

215 
Unfulfilled  contracts  as  contingent 

liabilities,  178 
Unissued  capital  stock,  134 
Unit  costs  or  earnings,  275 
Unit  period  of  interest,  527 
United  States, 
Census  Bureau, 
water  supply  systems,  uniform 
accounts,  678 


INDEX 


889 


United  States — continued 
Comptroller  of  Currency, 
national     bank     examination, 
545 
Corporations,  Bureau  of,  106 
Treasurer  of, 
balances    due    from    national 

bank,  538 
bonded    amount    of    national 

banks,  538 
circulation    redemption    fund, 
538 
U.  S.  Steel  Corporation,  intercom- 
pany profits  of,  213 
Usury    (See  interest,  520) 

V 
Vacations,  should  be  compulsory, 

57 
Valuation, 
assets,  217,  434 

Dickinson,  A.  Lowes,  on  market- 
able investments,  556 
"going    concerrt;"    and    "scrap" 

value,  107 
inventories,  84,  99 
public  utilities, 
compulsory,  645 
Interstate  Commerce  Commis- 
sion act,  645 
New  York  Telephone  Co.,  684 
securities  in  investment  compan- 
ies, 553 
Van  Doren,  A.  E.,  statement  for 

borrowers,  257 
Vehicles,  costs  in  retail  business, 

622 
Verification, 
balance  sheet  items  in  bank,  535 
bank  balances,  304 
cash  and  securities  in  bank,  535, 

536 
changeable  assets,  535 
footings  and  postings,  297 
income,  313 
inventories,  86 


of  finished  goods,  95 
rules  for,  88 
outstandings,  78,  320 
Vouchers,  334 
cancellation  of,  368 
cheques  as,  334 
journal,  366 
missing,  342 

petty  cash,  pay-rolls,  etc.,  342 
useless  checking  of.  338 
W 
Wages,  161,  358   (See  also  "Pay- 
roll") 
Wagons, 
depreciation  of,  426 
valuation  of,  118 
Wasting  assets,  134,  195,  232,  428 
Water  companies,  677 
accounting,    uniform    classifica- 
tion, 678 
municipal  ownership,  678 
rates,  161 
Weiss,  Wm.  F.,  on  principal  and 

income,  234 
Wholesale  merchants,  608 
Wildman,  John  R.,  on  trade  dis- 
counts, 227 
Wisconsin, 

Public  Service  Commission,  631 
Railroad  Commission, 
telephone  companies,  deprecia- 
tion, 682 
valuation    increase,    gas    and 
electric  light  company,  645 
Witness, 
can  testify  to  own  work  only, 

439 
expert,  auditor  as,  438 
Woodcuts,  120 
Work  in  progress,  209 
Working  capital,  196 
Working  papers, 
arrangement  for  audit,  38 
method  of  filing,  42 
preservation  of,  432 


14  DAY  USE 

RETURN  TO  DESK  FROM  WHICH  BORROWED 

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This  book  is  due  on  the  last  date  stamped  below,  or 

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Renewed  books  are  subject  to  immediate  recall. 


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